By Suil Lee, Professor at KDI School of Public Policy and Management
※ This article is part of KDI Journal of Economic Policy, February 2020
Regulations are everywhere. Our everyday lives are largely structured by regulations. Running a business is also greatly influenced by various types of regulation. Therefore, it is very important to maintain effective and efficient regulations in order to make our everyday lives better and to improve the competitiveness of our companies and even the level of national competitiveness.
However, finding unreasonable regulations around us is not at all difficult. For instance, regulations on opening hours for large marts, such as E-Mart, bring discomfort to consumers every weekend, with no positive impact on the revitalization of traditional markets, which was the initial purpose of the regulation. The differentiated broadcast advertising regulation is another example. From the standpoint of the viewer, although a terrestrial broadcasting channel and a pay broadcasting channel provide nearly identical services, differentiated advertising regulations continue between terrestrial broadcasting channels and pay broadcasting channels. For example, unlike pay broadcast channels, terrestrial broadcast channels are not allowed to include mid-program advertising. Not long ago as well there was a ridiculous case when a newly founded online car auction company called 'Hey Dealer’ was banned and was shut down, as online car auction companies were subjected to the same regulations as offline companies with regard to parking lots and auction facilities.
While it does not turn out to be obviously unreasonable, it is easy to find a controversial case regarding the legitimacy of a regulation. For example, currently in Korea, SK Telecom, the No. 1 mobile operator, is obliged to provide wholesale services for MVNOs with regulated wholesale prices. This regulation was introduced in 2010 to stimulate competition in the mobile telecommunications market and reduce the burden of the telecommunications costs for the public. The scope of the mandatory wholesale services and support for the MVNO continues to expand in the name of increasing the competitiveness of MVNOs. Recently, however, criticism has been raised, holding that the policy goal of activating competition in the mobile telecommunications market through MVNOs has already been largely achieved, and maintaining and expanding the regulation and support for MVNOs has undermined the incentives for MVNOs to secure their own competitiveness and eventually can hinder competition in the market.
All of these examples illustrate the importance of ex-post evaluations of regulations. Initially, most regulations are introduced to achieve socially desirable outcomes, but over time, if the environment surrounding regulation changes, the legitimacy of the regulation can be undermined. Changes in the environment can lead to discrepancies between regulatory objectives and regulatory measures, and even when regulatory objectives have already been achieved, regulations may continue to have negative side-effects. Therefore, it is highly socially desirable regularly to check the rationality and legitimacy of regulations and to maintain the quality of regulations through ex-post evaluations.
As a case study of the ex-post evaluation of regulations, in this paper I evaluate the ‘uniform settlement rate requirement’, a regulation that was introduced in 1986 and that had been applied to the international telephone market in the United States for more than 20 years.
The international message telephone service (IMTS) is somewhat unique in that it is provided jointly by two firms or carriers. It is this was simply because a single firm cannot operate the service on an end-to-end basis. As an example of an international call from the U.S. to a foreign country, a call that originates from a U.S. IMTS firm is carried to an international midpoint and is then transferred to a foreign IMTS firm which carries the call to the destination and terminates it. Because users only pay the U.S. firm, a compensation mechanism must exist between the two firms.
There is such a compensation mechanism, called the ‘international accounting rate system.’ Under this mechanism, two IMTS firms bargain over 1) the per-minute total expense for carrying a call from the origin to the destination, and 2) each firm’s portion of the per-minute total expense. The negotiated per-minute total expense is called the ‘accounting rate’, and each firm’s portion of the accounting rate is called the ‘settlement rate.’ Then, for an international call from the U.S., the U.S. IMTS firm pays the foreign firm a ‘settlement payment’ amounting to the foreign firm’s settlement rate times the number of minutes of the call. Because the U.S. has far more outgoing than incoming traffic for almost all foreign countries, U.S. carriers have paid foreign carriers large amounts in settlement payments. In 1996, for example, U.S. carriers paid $5.7 billion in net settlement payments for the termination of U.S. international calls, which amounts to 40% of all IMTS revenues.
Every U.S. IMTS firm has such an arrangement with regard to the accounting rate and settlement rate for each foreign country or international point. In principle, each U.S. carrier may have a different arrangement for the same foreign country. In 1986, however, the Federal Communications Commission (FCC) introduced the ‘International Settlement Policy (ISP)’ into the IMTS market. Among other things, it required U.S. IMTS firms to pay the same settlement rate to a foreign country for the termination of international traffic, referred to as the ‘uniform settlement rate requirement.’ Practically, the uniform settlement rate requirement has been implemented such that only one U.S. IMTS firm (mainly AT&T) entered into negotiations with foreign firms, and the resulting settlement rates were automatically applied to other U.S. firms. This requirement was applied to all foreign countries for nearly ten years, but since 1994 it has been lifted for many foreign countries, introducing significant competition into their IMTS markets. Nonetheless, in the mid-2000s, more than 100 countries operated under the requirement.
In fact, the uniform settlement rate requirement was implemented to remove entry barriers and to introduce competition into the IMTS market. After the imposition of this requirement, U.S. IMTS markets became increasingly competitive, and by 1992, three or more U.S. IMTS providers competed in the market for all main foreign countries. However, it also significantly changed the bargaining framework within which U.S. carriers negotiate with foreign carriers. Changes in the bargaining framework affect the relative bargaining positions of the IMTS carriers involved. There are two main routes through which the relative bargaining positions of the IMTS carriers are affected by the implementation of the requirement. First, the uniform settlement rate requirement may weaken U.S. carriers’ incentives to bargain aggressively over settlement rates, as they cannot gain any advantage during product market competition by lowering their own rates. This is referred to here as the ‘Competition-Induced-Incentive (CII) Effect.’ Second, it may also strengthen foreign carriers’ bargaining positions through what is termed the ‘Most-Favored- Nation (MFN) Effect,’ according to which whatever concession a foreign carrier gives to a specific U.S. carrier doubles. Because these two effects both have a negative impact on U.S. carriers’ bargaining positions, the uniform settlement rate requirement may have been detrimental to U.S. carriers during the negotiation of settlement rates. These ‘side-effects’ of the uniform settlement rate requirement will weaken or even eliminate the justification of the requirement, depending on their size. Hence, in terms of policy evaluations, it is very important to identify and measure these possible side-effects of the requirements of settlement rates, net settlement payments, and the total surplus in the U.S.
Given the potential for a negative impact from the uniform settlement rate requirement, this paper evaluates the uniform settlement rate requirement both theoretically and empirically, thereby providing a clear example which highlights the importance of conducting ex-post evaluations of regulations. First, in a theoretical model, I compare an actual regime in which the uniform settlement rate requirement is enforced with counterfactual regimes where various firm-specific settlement rates are allowed. I identify the presence of the Competition-Induced-Incentive Effect and the Most-Favored-Nation Effect in the actual regime and show that these two effects increase the settlement rate, thereby resulting in a higher settlement rate in the actual regime. It should be noted that U.S. carriers have an incentive to reduce settlement rates, as they have paid foreign carriers large net settlement payments. Second, I empirically measure the impact of the uniform settlement rate requirement, as found in the theoretical model, on the negotiated settlement rates, net settlement payments, and welfare in the U.S. My general strategy is to estimate a structural bargaining model of settlement rate negotiation and then conduct a counterfactual experiment using the estimated structural bargaining model.
The remainder of the paper is organized as follows. In Section 2, I discuss the ISP, and in particular, the uniform settlement rate requirement more extensively. In Section 3, I provide a theoretical model in which the competition-induced-incentive effect and the most-favored-nation effect are identified. In the next section, I suggest an empirical strategy and develop an econometric framework to measure the impact of the requirement on the settlement rates, settlement payments, and welfare. The data are described in Section 5. In Section 6, I present the estimation result for the bargaining model and conduct the counterfactual experiment. Finally, Section 7 concludes the analysis by summarizing the results of the experiment and suggesting several policy measures for strengthening the ex-post evaluations of regulations in Korea.