Application of real options theory to TELRIC models: real trouble or red herring
Since the inception of policy debates on opening local markets to competition, the incumbent local exchange carriers (ILECs) have argued against any costing methodology that would erode their monopoly level of revenue and profits. Real options issues were introduced to this debate at a time when the FCC was considering adopting TELRIC models to set rates for interconnection to the local exchange. The ILECs’ goal was to use these real options issues to undermine the credibility of the TELRIC methodology, leaving the FCC with no choice but to rely on embedded costs.
Although the theoretical issues raised by real options are legitimate and intriguing, they do not apply to the case at hand. The competitors’ use of the local network does not expose the ILECs to more risk than the typical customer. Customers of the ILECs have always had the option to use or not use the ILECs’ network, and the ILECs have never imposed a premium for option values on those customers. Indeed, the customers that imposed the greatest risk on the ILECs — the Centrex customers — frequently paid the lowest rates.
An attempt to measure the upper bound of the option value effect also shows that the ILECs will be fully compensated for the use of their network when prices are set at the levels estimated by the TELRIC models. The risk to the ILECs of a failure to recover the costs of sunk investments is greatest for portions of the local loop plant. Yet, this plant is shown to exhibit very large economies of scale, and the ILECs’ option to build a smaller-scale network is essentially valueless. The conditions that would render the real options theory as a killer critique of the use of the TELRIC models simply do not exist.
KeywordsReal Option Capital Asset Price Model Access Charge Universal Service Real Trouble
Unable to display preview. Download preview PDF.
- 2.J._ Hausman, “Reply Affidavit of Professor Jerry A. Hausman,” Before the Federal Communications Commission, CC Docket No. 96–98 (May 29, 1996), 1. It is difficult to sort out what Professor Hausman is referring to when he states that a “TSLRIC calculation” is biased by a factor of at least 2 and probably in excess of 3. Is he referring to the results of a TSLRIC model, or to some component in the model? The FCC’s rejection of Hausman’s thesis seemed to interpret his claim as referring to the “forward looking methodologies” per se (see FCC Order p. 688). This also comports with my recollection of the way in which the debate was conducted at the time. It is possible, however, that Professor Hausman’s statement was misinterpreted. In a later filed affidavit, he seems to have clarified his position that the bias only refers to the sunk portion of the investment (see Testimony of Jerry Hausman, April 7, 1998, before the California PSC).Google Scholar
- 4.Monson, C. and J. Rohlfs. July 16, 1993. The $20 Billion Impact of Local Competition in Telecommunications, Strategic Policy Research, Inc.Google Scholar
- 5.USTA Press Release. July 1993. “Potential Impact of Competition on Residential and Rural Telephone Service,” at 1.Google Scholar
- 7.“Defining and Funding Basic Universal Service: A Proposal of MCI Communications Corporation,” July 1994.Google Scholar
- 8.Hatfield Associates, Inc. July 1994. The Cost of Basic Universal Service.Google Scholar
- 14.Taylor, William E. October 16, 1996. Not the Real McCoy: A Compendium of Problems with the Hatfield Model, National Economic Research Associates, Inc. Prepared for United States Telephone Association, Ex Parte Filing at the FCC, CC Docket No. 96-45.Google Scholar
- 22.FCC. May 1999. “Preliminary Statistics of Communications Common Carriers, and New Paradigm Resources Group.” 1999 CLEC Report, 10th ed.Google Scholar
- 25.Northern Business Information. January 1996. The U.S. Central Office Equipment Market, Northern Business Information.Google Scholar
- 27.Gollop, Frank. October 22, 1998. “Attachment D to Comments of USTA,” Technical Report: Replication and Update of the X-Factor Constructed Under the FCC Rules. Gollop, Frank. November 5, 1998. “Attachment D to USTA Reply Comments,” Sensitivity Analysis of the FCC X-Factor to Changes in Economic Variables.Google Scholar
- 31.Id. ftn. 10. The reference cited by Hausman is: Lawrence Summers, “Investment Incentives and the Discounting of Depreciation Allowances.” 1987. The Effects of Taxation on Capital Accumulation, Martin Feldstein, ed. Chicago: University of Chicago Press.Google Scholar
- 33.See, Ibbotson Associates, Stocks Bonds Bills and Inflation, 1995 Yearbook, Table B-1 at 157.Google Scholar
- 34.Economic Report of the President, 1993, Table B-69 at 428.Google Scholar
- 37.AT&T. March 16, 1999. Affidavit of Bradford Cornell and John I. Hirshleifer, FCC CC Docket 98-166.Google Scholar
- 38.Another paper finds that price uncertainty does not affect investment in any but the most unconcentrated markets. See Goshal, Vivek and Prakash Loungani. June 1996. “Product Market Competition and the Impact of Price Uncertainty on Investment: Some Evidence from U.S. Manufacturing Industries,” Journal of Industrial Economics.Google Scholar
- 39.Caballero, Ricardo and Robert S. Pindyck. September 1995. “Uncertainty, Investment, and Industry Evolution,” Discussion Paper, M.I.T.Google Scholar
- 45.Trigeorgis, Lenos. 1996. Real Options, Managerial Flexibility and Strategy in Resource Allocation. Cambridge Massachusetts: The MIT Press, at 348.Google Scholar