AT&T AND T-MOBILE: ECONOMIES AS AN ANTITRUST DEFENSE                      APPLIED                                         ...
competed along some dimensions at both the local and national levels, and that at the local levels both theirmarket shares...
reverse the merger’s potential to harm customers in the relevant market, e.g., by preventing price    increases in that ma...
The second category of efficiencies, estimated in the Application at $39 billion total, “with an annual runrate on the ord...
threshold that is used at the Antitrust Division in determining whether GUPPI levels raise unilateral effectsconcerns” – b...
its business…. As a result, the Applicants significantly overstate the estimated cost savings of the proposedtransaction.”...
3. THE LITERATURE ON SCALE ECONOMIES, PARTICULARLY IN NETWORK INDUSTRIESEarly, seminal texts by Marshall and Viner discuss...
and points served made possible by a proportional increase in all inputs, with average stage length,         average load ...
“If the econometric models were to be relied on, there would be a strong case for pursuing         infrastructure competit...
the range of constant returns to scale.41 The only paper I have found directly related to economies ofdensity in local mob...
of the world regarding the existence of unexhausted economies of firm size and metropolitan area densityin the provision o...
the purpose of the merger application. As noted earlier, the basis of a good deal of the efficiencies claimswas the superi...
is it really credible that the firm cannot achieve such economies through organic growth – that theachievement of these ec...
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Paper_AT&T and T-Mobile: Economies as an Antitrust Defense Applied

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NES 20th Anniversary Conference, Dec 13-16, 2012
The article "AT&T and T-Mobile: Economies as an Antitrust Defense Applied" presented by Russell Pittman at the NES 20th Anniversary Conference.
Authors: Russell Pittman and Yan Li

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Paper_AT&T and T-Mobile: Economies as an Antitrust Defense Applied

  1. 1. AT&T AND T-MOBILE: ECONOMIES AS AN ANTITRUST DEFENSE APPLIED Russell Pittman*and Yan Li# ABSTRACTFrom the beginning, the debate on the likely results of the proposed acquisition of T-Mobile USA by AT&T focusedmore on the claims of the parties that “immense” merger efficiencies would overwhelm any apparent losses ofcompetition than on the presence or absence of those losses, and the factors that might affect them, such as marketdefinition. The merging companies based their “economic model” of the merger on estimates of efficiencies derivedfrom AT&T’s “engineering model”, without addressing the credibility of the results of the latter in the context of theeconomics literature on the telecommunications sector. This paper argues that the economics literature on economiesof scale (especially) and economies of density in mobile telephony and elsewhere suggests caution in expecting suchmassive cost reductions from increasing the size of an already very large firm. It closes with an argument for theapplication of this perspective, where appropriate, in future discussions of merger efficiencies.JEL: K21, L40, L961. INTRODUCTIONAT&T’s proposed $39 billion acquisition of T-Mobile USA (TMU) raised serious concerns for U.S.policymakers, particularly at the Federal Communications Commission (FCC) and the Antitrust Division ofthe Department of Justice (DOJ), which shared jurisdiction over the deal. 1 Announced on March 20, 2011,the acquisition would have combined two of the four major national providers of mobile telephony servicesfor both individuals and businesses, with the combined firm’s post-acquisition share of revenues reportedlyover 40 percent, Verizon a strong number two at just under 40 percent, and Sprint a distant number three ataround 20 percent.2 As usual in a large and complex merger deal, there were questions about how exactly to definemarkets, in both the product and geographic dimensions. In the former category were the questions of bothwhether prepaid and postpaid services and whether individual and business (“enterprise”) services mightconstitute separate markets; in the latter category, it was noted that the four major national suppliers* Antitrust Division, U.S. Department of Justice, Washington, DC, and New Economic School, Moscow. Email:Russell.Pittman@usdoj.gov. The author worked as a staff economist in the DOJ investigation of the AT&T/T-Mobilemerger proposal. However, this paper has been written using only public sources of information. He is grateful to hiscolleagues Norm Familant, Pat Kuhlman, and Bob Majure for helpful comments and suggestions. The views expressedare not purported to reflect the views of the Department of Justice.# Norwich Business School and Centre for Competition Policy, University of East Anglia, Norwich, NR4 7TJ, UK.Email: Li.Yan@uea.ac.uk.1 See Laura Kaplan, Note, One Merger, Two Agencies: Dual Review in the Breakdown of the AT&T-T-Mobile Mergerand a Proposal for Reform, BOSTON COLL. L. REV. forthcoming, and papers cited therein, for a discussion of issuesraised by the shared jurisdiction of the two federal agencies.2 Federal Communications Commission, Annual Report and Analysis of Competitive Market Conditions With Respectto Mobile Wireless, Including Commercial Mobile Services (14th Report, May 20, 2010; Allen Grunes and MauriceStucke, Antitrust Review of the AT&T/T-Mobile Transaction, 64 FED. COMM. L. J. 47 (2011); see also Stanley Besen,Stephen Kletter, Serge Moresi, Steven Salop, and John Woodbury, An Economic Analysis of the AT&T-T-Mobile USAWireless Merger, Charles River Associates, April 19, 2012, and Maurice Stucke and Allen Grunes, The AT&T/T-Mobile Merger: What Might Have Been?, 3 J. EUR. COMP. L. & PRACTICE (2012). In its Complaint, DOJemphasized not market shares but changes in the Herfindahl Hirschman Index (HHI): “Nationally, the proposedmerger would result in an HHI of more than 3,100 for mobile wireless telecommunications services, an increase ofnearly 700 points.” Complaint at ¶25; http://www.justice.gov/atr/cases/f274600/274613.htm. 1
  2. 2. competed along some dimensions at both the local and national levels, and that at the local levels both theirmarket shares and the identity and importance of additional competitors varied to some degree. Both DOJ(in its Complaint, filed on August 31, 2011)3 and the staff of the FCC (in its Staff Analysis and Findings,filed on November 29, 2011)4 argued that the merger would be anticompetitive regardless of the choicesmade on these more specific market definition questions. An interesting and unusual aspect of the debate that ensued following the announcement of the merger,through the issuing of the DOJ complaint and the FCC staff report, until the companies abandoned themerger project on December 19, 2011, was that the merging firms did not seem to devote much effort to thepresentation of evidence against the market definitions that implied these high levels of concentration. Thecompanies’ principal economic experts, Dennis Carlton, Allan Shampine, and Hal Sider (hereinafter CSS),in their Declaration filed at the FCC with the merger proposal, stated the basis of their support for themerger in very clear terms: “We conclude that the proposed transaction will promote competition byenabling the merged firm to achieve engineering-based network synergies that increase network capacitybeyond the levels that AT&T and T-Mobile USA could achieve if the two companies continued to operateindependently.”5 The Declaration proceeded to emphasize that the merged firm would continue to face competition froma variety of sources, as well as arguing that the standard “unilateral effects” analysis expected from DOJwould be misleading for a variety of industry- and situation-specific reasons.6 However, it did not takestrong issue with the basic market definition and concentration analysis that it deemed likely flow from theHorizontal Merger Guidelines of DOJ and the Federal Trade Commission. 7 In their Reply Declaration(June 9), CSS stated the point even more starkly: “These consumer benefits are independent of the scopeof the product and geographic markets and, as a result, the precise definitions of the product and geographicmarkets are not central to the evaluation of the proposed transaction.”8 Thus, in defending their proposed merger, the parties invoked specific language in the HorizontalMerger Guidelines of the U.S. Department of Justice and the Federal Trade Commission concerning one setof circumstances under which claims of efficiencies might cause the agencies to decide not to challenge anotherwise anticompetitive merger. The Guidelines, after noting that claimed efficiencies must be bothverifiable and merger-specific in order to be “cognizable,” summarize the agencies’ position as follows: “The Agencies will not challenge a merger if cognizable efficiencies are of a character and magnitude such that the merger is not likely to be anticompetitive in any relevant market. To make the requisite determination, the Agencies consider whether cognizable efficiencies likely would be sufficient to3 http://www.justice.gov/atr/cases/f274600/274613.htm.4 http://hraunfoss.fcc.gov/edocs_public/attachmatch/DA-11-1955A2.pdf.5 Declaration at ¶7; http://apps.fcc.gov/ecfs/document/view?id=7021240428.6 Declaration at ¶9.7 This was noted at the time by others as well. See, for example, Howard Chang, David Evans, and RichardSchmalensee, AT&T/T-Mobile: Does Efficiency Really Count? CPI ANTITRUST CHRON. 2 (2011): “AT&T’seconomists do not seem to be in significant disagreement with these product and geographic definitions” (i.e., those inthe DOJ Complaint).8 ¶59; http://apps.fcc.gov/ecfs/document/view?id=7021686850. 2
  3. 3. reverse the merger’s potential to harm customers in the relevant market, e.g., by preventing price increases in that market.”9In this case, AT&T and TMU were arguing exactly the latter point: that the efficiencies created by themerger would be so great that the merger would result in lower prices in the market. This paper seeks to place these very large merger efficiency claims presented by AT&T and TMU inthe context of the cost structure of mobile telephony and other network industries. Section 2 of the paperexamines more closely the efficiencies claims made by the parties and their implications. Section 3considers these claims in the context of the economic literature on economies of scale and economies ofdensity. We suggest there that the parties’ claims of efficiencies, while certainly not outside the realm ofpossibility, were remarkably high for a company already as large and with as high a market share asAT&T. Section 4 argues that even if the efficiency estimates were credible, they would suggest strongincentives for the merging companies to achieve them unilaterally, and thus cast doubt on the merger-specificity of the efficiencies.2. THE EFFICIENCIES CLAIMED BY THE MERGING FIRMSIn their FCC application and later in more detail at the agencies, the merging companies highlighted twocategories of efficiencies that would result from the merger. The first category, apparently not quantified ina single summary figure, constituted cost savings that were a primary output of the companies’“engineering model” and in turn a primary input into the CSS “economic model” of the impact of themerger. (Both models were in fact introduced into the FCC record subsequent to the filing of the mergerapplication and the CSS Declaration.) These cost savings were summarized by the companies as follows: “[T]he transaction will enable the merged firm to create far greater capacity on the combined network than the two networks could achieve on their own by (i) creating a denser network with additional cell sites that increase aggregate capacity; (ii) increasing spectrum available to provide service by consolidating redundant GSM network control channels; (iii) increasing the efficiency of existing spectrum through ‘channel pooling’; (iv) making greater use of underutilized networks; and (v) freeing up spectrum for more spectrally efficient services and thereby expanding the number of areas in which such services will be deployed. In so doing, the transaction will give the combined company much- needed flexibility to relieve capacity constraints by enabling it to optimize its use of spectrum on a market-by-market basis….”109 U.S. Department of Justice and Federal Trade Commission, HORIZONTAL MERGER GUIDELINES (2010), at ¶10,footnotes omitted. The exercise is thus different from the “Williamsonian tradeoff”, under which merger proponentsseek to justify on total welfare grounds a merger that would be objectionable on consumer welfare grounds – in otherwords, arguing that harm to welfare (in the form of reductions in consumer surplus) from anticompetitive priceincreases following a merger may be acceptable if it is smaller in magnitude than gains to welfare (in the form ofincreases in producer surplus) from reductions in cost. In the AT&T/TMU merger, the companies were arguing thatthere would be no reduction in consumer surplus in the first place. The Williamsonian tradeoff was introduced inOliver E. Williamson, Economies as an Antitrust Defense: The Welfare Tradeoffs, AMER. ECON. REV. 58 (1968) 18,and has been the subject of broad discussion in the economics and legal literature.10 Application at p. 42; http://apps.fcc.gov/ecfs/document/view?id=7021240421. 3
  4. 4. The second category of efficiencies, estimated in the Application at $39 billion total, “with an annual runrate on the order of $3 billion from year three forward,” included more efficient use of the cell towersowned by the two companies (including the sale of those no longer needed post-merger), as well aseconomies in combining retail operations, customer support, marketing, and procurement, the latterincluding “handsets as well as network equipment and infrastructure.”11 As noted above, the public record appears to contain no single dollar figure or percentage costreduction for the efficiencies claimed by the companies in their “engineering model.” However, thecompanies’ Application at the FCC described them as “immense,”12 and the subsequent filing by thecompanies in “Opposition … to Petitions to Deny” promised that the merger would create “immense newcapacity that will provide enormous benefits to consumers.”13 We can take steps toward more preciseinferences concerning the magnitude of these claims of efficiencies by combining information from variouspublic sources. First, the FCC staff report summarizes the companies’ redacted analysis as concluding that followingthe merger, “prices would fall between 3.8 and 9.4 percent.”14 Second, a redacted letter from AT&Tcounsel to the FCC, accompanied by a redacted slide presentation titled “Competitive Effects of the AT&T– T-Mobile Transaction,” notes that the economic model presented by CSS assumes linear demand in orderto be on the conservative side regarding the pass-through of cost reductions to consumers. 15 Since standardeconomic theory holds that firms facing linear demand pass through approximately fifty percent of costchanges,16 this by itself would suggest that the parties are claiming cost reductions of between 7.6 and 18.8percent. But the same presentation implies that – as usual in merger simulation – the model would predict apost-merger price increase if there were no efficiencies: “Our analysis indicates that the cost and qualitybenefits are more than sufficient to counter any upward pricing pressure....”17 Similarly, AT&T economistMark Israel noted in the FCC’s “Workshop on the Economics of the Proposed AT&T – T-Mobile Merger”that “what really drives the results is the change in the AT&T marginal cost, and whether that’s largeenough to overcome the competitive effects.”18 Finally, in their Reply Declaration (June 9, 2011), CSSdiscuss the “Upward Pricing Pressure Analysis” calculated by Stephen Salop, Stanley Besen, StephenKletter, Serge Moresi, and John Woodbury (hereinafter SBKMW) and submitted on May 31 on behalf ofSprint’s opposition to the merger. CSS report that, after making some but not all of their proposedcorrections to the SBKMW model, the model predicts upward pricing pressure “not very far from the11 Application at pp. 51-52.12 Application, at 12 and 23.13 at 1; http://apps.fcc.gov/ecfs/document/view?id=7021686831 (June 10, 2011).14 Staff Analysis at ¶136.15 http://apps.fcc.gov/ecfs/document/view?id=7021704486, August 23, 2011. A later document titled ”Explanation ofthe Compass Lexecon Merger Simulation Model,” by Dennis Carlton and Mark Israel, filed on October 24, 2011,makes the same point: http://apps.fcc.gov/ecfs/document/view?id=7021717659.16 See, for example, Glen Weyl and Michal Fabinger, A Restatement of the Theory of Monopoly, unpublished paper,June 2011, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1851326.17 Slide 3, emphasis added.18 Transcript at 251, emphasis supplied; http://apps.fcc.gov/ecfs/document/view?id=7021711835. 4
  5. 5. threshold that is used at the Antitrust Division in determining whether GUPPI levels raise unilateral effectsconcerns” – by which a footnote explains that they mean 5 percent (¶87). 19 Thus the efficiencies claimed must reduce the price not from its current level but from its higher but-for level – adding a figure “not very far from” 5 percent into the mix, so perhaps 6 to 7 percent.Furthermore, the letter and the Application strongly emphasize that the efficiencies included in this pricinganalysis should be considered an underestimate of the true efficiencies to be expected from the merger –that the efficiencies included in the “economic model” do not, for example, include the $39 billion ofefficiencies included in the second category discussed above. Thus we may infer with some confidence that the parties were claiming cost reductions from themerger at least in the range of our earlier estimate of 7.6 to 18.8 percent plus twice the 6 to 7 percent priceincreases we have inferred (because of the assumption of 50 percent cost pass-through): a total of 19.6 to32.8 percent cost reductions. Interestingly, the working paper progeny of SBKMW calculates“compensating marginal cost reductions” separately for AT&T and TMU and finds that the reduction inmarginal costs necessary to prevent any price increases from the merger would be 11.2 percent and 23.9percent, respectively.20 Since the merging parties claimed that the “immense” efficiencies would result inprice reductions, our figures seem broadly consistent with these. We argue in the next section of the paperthat this magnitude of cost reductions is a fairly remarkable claim for an already very large provider ofmobile telephone services. First, however, let us note that the FCC staff was quite sceptical of these efficiency claims – labellingthem “seriously flawed”, “implausible”, and “extremely sensitive to adjustments” – though on the groundsof a close examination of the engineering model on which they were based rather than on the groundsutilized in this paper. 21 According to the Staff Analysis, the companies calculated merger efficiencies byprojecting the costs of the two firms going forward independently, as demand increases and capacity levelsare reached at the level of local markets, and then comparing those but-for costs with the costs of thecombined firm under the same conditions. The staff objected first to the companies’ extrapolation of theircalculations for fifteen local markets to the totality of areas served by the two firms, as “the fifteen marketschosen by the Applicants do not seem to be particularly representative.”22 More fundamentally, though, the staff believed that the methodology used to calculate costs in the but-for world “contains a serious flaw in the cell-splitting algorithm that appears to cause the model to greatlyoverestimate incremental costs, and the overestimate is much greater for the standalone firms than themerged firm.”23 In particular, the strategy by which the companies were assumed to address growingtightness in capacity “is not rational and does not reflect how any wireless provider would operate or model19 SBKMW Declaration: Appendix A to http://apps.fcc.gov/ecfs/document/view?id=7021675883. CSS ReplyDeclaration: http://apps.fcc.gov/ecfs/document/view?id=7021686850.20 Stanley Besen, Stephen Kletter, Serge Moresi, Steven Salop, and John Woodbury, An Economic Analysis of theAT&T-T-Mobile USA Wireless Merger, Charles River Associates, April 19, 2012.21 Staff Analysis at ¶138.22 ¶169.23 ¶147. 5
  6. 6. its business…. As a result, the Applicants significantly overstate the estimated cost savings of the proposedtransaction.”24 Finally, note that at least one component of the second category of claimed efficiencies appears toconfuse private benefits with public benefits. One of the sub-categories is labelled “cost savings … fromcombining the networks”, and one element of this subcategory is described as follows: “savings from areduction in interconnection and toll expenses as a result of switching [T-Mobile calls] to existing AT&Tfacilities where possible for transport.”25 There is no estimate reported of the value of these efficiencies,though the sub-category of which they are a part is estimated to provide efficiencies of $10 billion in netpresent value.26 The FCC staff report identifies the “reduction in interconnection and toll expenses” as one of manyelements of the efficiencies claims where it is difficult to determine what portion of the efficiencies shouldbe counted as savings in fixed charges and what portion in variable charges, under the traditional thinkingthat savings in the latter are more likely to be passed along downstream in the form of lower prices than aresavings in the former.27 It appears, however – it is impossible to be sure from the public record – that the FCC staff critiquedoes not go far enough in this case. As a matter of standard economics, the actual amount ofinterconnection and toll expenses that are paid by TMU to AT&T pre-merger and would be internal to thefirm post-merger should count as a transfer, not a savings in resources. The only portion of this flow thatconstitutes a true efficiency comes from the fact that the internal transfer price for this service should be atmarginal cost rather than something higher, in which case “double marginalization” is avoided and themerged firm would have the incentive to expand output accordingly. Both CSS and their fellow AT&Tconsultants Robert Willig, Jonathan Orszag, and Jay Ezrielev note that the merger eliminates pre-mergerdouble marginalization in this area, but neither these nor other statements sponsored by the merging firmsstate that the resulting merger efficiencies are only those flowing from this particular incentive for outputexpansion, rather than the entire volume of cost savings from the internalization of these flows. 2824 ¶¶175-76.25 Declaration of Rick L. Moore, at ¶34 (http://apps.fcc.gov/ecfs/document/view?id=7021240425). Virtually the samelanguage is in the parties’ merger application to the FCC, at p. 52.26 Declaration of Rick L., Moore, at ¶34.27 FCC Staff report, at ¶228. Note that CSS argue that this principle should not apply in this matter, on the groundsthat, especially in “high tech industries”, “lower fixed costs today can encourage research and development, newproducts and plants in the future” (at ¶65-71, citing Carlton, Does Antitrust Need to Be Modernized? J. ECON.PERSPECTIVES 21 (2007) 155).28 CSS Reply Declaration at ¶143; Willig, Orszag, and Ezrielev Reply Declaration(http://apps.fcc.gov/ecfs/document/view?id=7021686853) at footnote 106. 6
  7. 7. 3. THE LITERATURE ON SCALE ECONOMIES, PARTICULARLY IN NETWORK INDUSTRIESEarly, seminal texts by Marshall and Viner discussed the importance of “net internal economies of large-scale production.”29 Kahn and others applied this concept to the possibility that a single firm might be a“natural monopoly … [where there] is an inherent tendency to decreasing unit costs over the entire extentof the market.”30 Some commentators have applied this concept to the AT&T/T-Mobile merger. Forexample, an analyst from the Congressional Research Service noted that “The mobile wireless industry is characterized by economies of scale and scope. In a static market, it would be less costly and/or more efficient to build out and operate a single network instead of multiple networks with partially duplicative facilities; to give a single provider use of a large block of spectrum rather than giving a number of providers use of a subset of that block; and to design and mass produce a single suite of handsets rather than making handsets for smaller groups of customers using many different standards and network technologies.”31 This sounds reasonable, and yet it seems to suggest at least two follow-up questions. First, are weconsidering here local or national economies of scale? And second, do these economies exist for allrelevant levels of demand – so that the firm may be a “natural monopoly” – or are they exhausted at somepoint, after which increases in output are accompanied by proportional or even greater than proportionalincreases in cost? Regarding the first question, for decades now the economic literature on network industries has madethe useful distinction between economies of overall system size or output and economies of density.Walters summarizes the difference succinctly in the railways context: “A significant development in all of this research [in “rail cost analysis”] was refining the distinction between economies of scale and density. The latter is the behavior of costs as output expands over a given network, whereas economies of scale focuses on the behavior of costs if the network size increases as output expands.”32Similarly, Caves, Christensen, and Tretheway make the distinction in their analysis of airline costs: “We define returns to density as the proportional increase in output made possible by a proportional increase in all inputs, with points served, average stage length, average load factor, and input prices held fixed…. We define returns to scale as the proportional increase in output29 Alfred Marshall, PRINCIPLES OF ECONOMICS, 8th Ed. (1920; repr. 1982); Jacob Viner, Cost Curves and SupplyCurves, in George Stigler and Kenneth Boulding, eds., READINGS IN PRICE THEORY (1952), repr. fromZEITSCHRIFT FÜR NATIONALÖKONOMIE (1931).30 Alfred E. Kahn, THE ECONOMICS OF REGULATION: PRINCIPLES AND INSTITUTIONS (1971).31 Charles Goldfarb, The Proposed AT&T/T-Mobile Merger: Would It Create a Virtuous Cycle or a Vicious Cycle?Washington, DC: Congressional Research Service, May 10, 2011.32 William G. Waters II, Evolution of Railroad Economics, in Scott Dennis and Wayne Talley, RAILROADECONOMICS (RES. TRANS. ECON. 20 (2007) 11. 7
  8. 8. and points served made possible by a proportional increase in all inputs, with average stage length, average load factor, and input prices held fixed.”33 It seems useful, indeed important, to make this distinction in the present case of the market for mobiletelephony. A significant portion of the economies claimed by AT&T for the merger seem to be somevariant on economies of density, involving as they do the more efficient utilization of (especially) spectrumand cell towers in particular metropolitan areas. However, other claimed economies are firm-wide in scopeand independent of the density of local areas, including those associated with marketing, customer service,procurement, and overall company administration, and so seem to be instances of more traditionaleconomies of firm scale. All of this raises the crucial question: How reasonable is it to assume that under current (i.e. withoutthe merger) conditions, AT&T and T-Mobile enjoy substantial unexhausted economies of both density andsize of national operations? Recall that the information and arguments made publicly by the firms suggestclaims of at least 19-20 percent reductions in cost, and perhaps 32 percent or more. Absent an up-do-dateeconometric examination of mobile telephony for the US as a whole as well as for individual metropolitanareas, what can we infer from the existing literature? The literature on at least one other network industry is not particularly supportive. In the freightrailways sector, the literature suggests that in Western Europe, the railways have reached efficient scale interms of system size but have not exhausted all available economies of density. 34 In the much larger andmore intensely operated US freight railroads, however, the most recent study suggests that the largestcompanies have reached or are reaching minimum efficient scale in both system size and density.35 What about mobile telephony? Here we are hampered by both the very dynamic nature of the industry– so that even fairly recent data may not well reflect economies going forward – as well as the paucity ofpublicly available data, especially regarding economies of density. One of the most knowledgeable of U.S.analysts, Ingo Vogelsang, in a survey article laments the lack of convincing studies but seems to leantoward believing in constant returns to scale, even with regard to economies of density: “The case for constant returns comes from the observation that a doubling of traffic leads to cell splitting and increases the number of cells required even in the same area, roughly doubling costs.”36Writing eight years earlier, Cave, Majumdar, and Vogelsang seem to be of the same view:33 Douglas Caves, Laurits Christensen, and Michael Tretheway, Economies of density versus economies of scale: whytrunk and local service airline costs differ, RAND J. ECON. 15 (1984) 471, emphasis in original.34 See the discussion in Russell Pittman, Options for Restructuring the State-Owned Monopoly Railway, in Dennis andTalley, op. cit., discussing, among others, the results of M.G. Savignat, and Chris Nash, The case for rail reform inEurope: Evidence from studies of production characteristics of the rail industry, INTL. J. TRANS. ECON. 26 (1999)201.35 Christensen Associates, A Study of Competition in the U.S. Freight Railroad Industry and Analysis of Proposals thatMight Enhance Competition, U.S. Surface Transportation Board, 2008.36 Ingo Vogelsang, The relationship between mobile and fixed-line communications: A survey, INFORMATIONECON. & POL. 22 (2010) 4. 8
  9. 9. “If the econometric models were to be relied on, there would be a strong case for pursuing infrastructure competition throughout the network. If the engineering models were to be relied on, infrastructure competition in local areas would make sense only in very dense networks, where economies of density are exhausted…. [C]onceptually, there could exist two important ranges of natural monopoly. In the first stage, the natural monopoly property can be weak. In this range, economies of scale and scope are almost exhausted and sunk costs tend to be small. In this situation, competition is likely to be beneficial, because it leads to pressure on costs, prices and innovation. Competition is also likely to occur here, because in most telecommunications markets demand is moderately to strongly inelastic. Thus, we can expect duplicate network investments, associated with some cost inefficiency and excess capacity, but possibly lower prices than under regulated monopoly. This is the case of long-distance services, mobile telephony and local business services in downtown areas of industrialized countries.”37 In fact, the parties’ own engineering experts concede at least the possibility of the effective exhaustionof economies of density in one area: they note that “the percentage gains from channel pooling diminish asthe size of the pool increases”.38 And all of this would be consistent with the findings of Gabel and Kennet– also based on an engineering model – that for the local fixed wire network, economies of density areexhausted in densely populated urban areas.39 Most of the existing empirical literature features observations at the firm level, with output measuredas number of subscribers or, less frequently, revenues or airtime minutes. These studies tend to findconstant returns to scale or even, eventually, decreasing returns to scale for the largest operators – i.e.,generally U-shaped cost curves. These papers include those by McKenzie and Small, examining five U.S.firms; Gagnepain and Pereira, three Portuguese firms; Vendruscolo and Alves, 38 Brazilian firms (thenumber declining over time); and Nam, Kwon, Kim, and Lee, three Korean firms. 40 My work with Yan Lialso finds a U-shaped cost curve for mobile telephony at the firm level in an international sample, with afew firms each in ranges of increasing and decreasing returns to scale, but with AT&T and TMU both in37 Martin Cave, Sumit Majumdar, and Ingo Vogelsang, Structure, Regulation and Competition in theTelecommunications Industry, in Cave, Majumdar, and Vogelsang, eds., HANDBOOK OFTELECOMMUNICATIONS ECONOMICS, VOL. 1: STRUCTURE, REGULATION AND COMPETITION (2002).38 However, they proceed to suggest that “the vast majority” of locations served by the merging firms still “havecharacteristics that will permit large gains.” Jeffrey Reed and Nishith Tripathi, “AT&T/T-Mobile: Further Analysis ofCapacity, Spectrum Efficiency and Service Quality Gains from Network Integration”, at p. 7.39 The authors find that those geographic areas with unexhausted economies of density (though they do not use thisterm) exhibit “slightly higher than the high end of the density found in districts dominated by single family homes”David Gabel and Mark Kennet, Estimating the Cost Structure of the Local Telephone Exchange Network, Report No.91-16, National Regulatory Research Institute, October 1991, at 77.40 David McKenzie and John Small, Econometric Cost Structure Estimates for Cellular Telephony in the United States,J. REG. ECON. 12 (1997) 147; Philippe Gagnepain and Pedro Pereira, Entry, costs reduction, and competition in thePortuguese mobile telephony industry, INTL. J. IND. ORG. 25 (2007) 461; Maria Ivanice Vendruscolo and TiagoWickstrom Alves, Study of the scale economy in the Brazilian mobile telecommunication sector after privatizations (inPortuguese), REV. CONTABILIDADE & FIN. (2009); Changi Nam, Youngsun Kwon, Seongcheol Kim, andHyeongjik Lee, Estimating scale economies of the wireless telecommunications industry using EVA data, TELL. POL.33 (2009) 29. 9
  10. 10. the range of constant returns to scale.41 The only paper I have found directly related to economies ofdensity in local mobile telephone markets uses internal, local market level data for GTE, at the time asupplier in primarily rural areas with coverage of a few urban areas in California and Florida, and findseconomies with respect to the number of subscribers, controlling for airtime minutes per cell site.However, even this paper finds economies for mobile telephony “below those that have been estimated forwireline technology.”42 In (unsatisfying) summary, the literature suggests that it is unlikely that a firm as large as AT&T – andperhaps T-Mobile as well – is operating at a point on its overall enterprise cost curve of substantialunexhausted economies of scale. With regard to economies of density at the metropolitan level, the littleevidence available is more supportive of the presence of at least some unexhausted economies of density insome locations, though not in the most dense urban areas. But even in that case we may justifiably askwhether if one believes the evidence of “immense” economies presented by the merging companies, oneshould take the next step and consider whether mobile telephony in U.S. cities is a natural monopoly, withdeclining costs throughout the relevant regions of demand? In fact, one party challenging the merger at the FCC, the Ad Hoc Telecommunications UsersCommittee, makes this precise point, both on its own and in a Declaration by economist Lee Selwyn. Thetwo begin by noting the tension between the merging parties’ contention that only this merger can ease thecapacity constraints faced by each firm separately and the their simultaneous contention that the mergercould not be anticompetitive because much smaller firms like MetroPCS and Cellular South could easilyexpand in order to discipline any post-merger price increase. They then go on to make the argument that iffirms as large as AT&T and T-Mobile can achieve “immense” cost reductions through merging theiroperations, presumably AT&T, T-Mobile, and Verizon would achieve even greater economies by merging.In other words, if the efficiencies claimed by the parties are correct, then unless (for example) economies ofdensity in the industry are coincidentally exhausted at the point of around 40 percent of current capacity –and the parties make no such claim, much less provide evidence for it – then mobile telephony may well bea sector characterized by natural monopoly, and the FCC should rely on regulation rather than competitiongoing forward. The FCC staff analysis does not appear to address this point. CSS, in their Reply Declaration, simplystate that in that case every industry in which merging parties claim economies of scale or scope must be anatural monopoly – hardly a convincing response, given the traditional relevance of the concept of naturalmonopoly in infrastructure sectors such as telecommunications. Certainly, overall it seems that theeconomic analysis that uses the engineering model and its associated efficiencies claims in support of aprecompetitive outcome to this merger is implicitly assuming a very specific, and arguably unlikely, state41 Yan Li and Russell Pittman, The proposed merger of AT&T and T-Mobile: Are there unexhausted scale economies inU.S. mobile telephony? U.S. Department of Justice, Antitrust Division, EAG Discussion Paper 12-2, 2012.42 R. Dean Foreman and Edward Beauvais, Scale Economies in Cellular Telephony: Size Matters, J. REG. ECON. 16(1999) 297. 10
  11. 11. of the world regarding the existence of unexhausted economies of firm size and metropolitan area densityin the provision of mobile telephony, with no econometric support.434. DISCUSSIONThe proposed acquisition of TMU by AT&T raised to an unusually prominent position a challenge facedwith some frequency by competition agencies around the world: how to evaluate efficiencies claims madeby merging (or otherwise investigated) firms. There are serious information asymmetries inherent inattempts to evaluate such claims, as well as obvious incentives for the side with the superior information topresent a biased analysis. The fact that the merging firms commissioned an efficiencies analysis by engineers that was in turn aprincipal input into the competitive analysis by economists brings to mind a second traditional area ofdiscussion in the economics literature: the old controversy between “statistical models” of cost and“engineering models”.44 This argument seems to have come to a truce many years ago, as both sidesconceded not only individual weaknesses but a common inability to estimate or forecast with confidence“outside the sample”. In particular for our purposes, as described by a later survey article, “engineeringestimates are based on rapidly decreasing expertise as they seek to assess the effects of scale increasessubstantially beyond available experience.” 45 The Horizontal Merger Guidelines of the two U.S. agencies express the following overall perspectiveregarding efficiencies claims: “Efficiencies are difficult to verify and quantify, in part because much of the information relating to efficiencies is uniquely in the possession of the merging firms. Moreover, efficiencies projected reasonably and in good faith by the merging firms may not be realized. Therefore, it is incumbent upon the merging firms to substantiate efficiency claims so that the Agencies can verify by reasonable means the likelihood and magnitude of each asserted efficiency, how and when each would be achieved (and any costs of doing so), how each would enhance the merged firm’s ability and incentive to compete, and why each would be merger-specific. “Efficiency claims will not be considered if they are vague, speculative, or otherwise cannot be verified by reasonable means. Projections of efficiencies may be viewed with skepticism, particularly when generated outside of the usual business planning process.” 46 In the AT&T/TMU investigation, the merging parties presented claims of very large efficiencies thatwere based to a high degree on the results of a complex engineering model apparently created especially for43 See also T. Randolph Beard, George Ford, Lawrence Spiwak, and Michael Stern, Wireless Competition underSpectrum Exhaust, Phoenix Center for Advanced Legal and Economic Public Policy Studies, February 2012. Thistheoretical paper examines competition in mobile telephony under the twin assumptions of a binding spectrumconstraint and economies of scale in mobile telephony that are never exhausted. Unsurprisingly, such a model yieldsthe conclusion that a more concentrated market yields higher welfare.44 The classic references here are Hollis Chenery, Engineering Production Functions, QUART. J. ECON. 63 (1949) 501and Caleb Smith, Survey of the Empirical Evidence on Economies of Scale, in BUSINESS CONCENTRATION ANDPRICE POLICY (NBER, 1955).45 Bela Gold, Changing Perspectives on Size, Scale, and Returns: An Interpretive Survey, J. ECON. LIT. 19 (1981) 5,23.46 Guidelines at ¶10. 11
  12. 12. the purpose of the merger application. As noted earlier, the basis of a good deal of the efficiencies claimswas the superior ability of one firm to allocate the productive assets owned by the two firms in crowdedurban areas – and in particular to allocate the limited supply of spectrum in the face of skyrocketingconsumer data use.47 Were the claimed efficiencies – as noted above, in the range of 1/5 to 1/3 cost savings – credible in thiscontext? On the one hand, the Horizontal Merger Guidelines look with some favor on “efficienciesresulting from shifting production among facilities formerly owned separately, which enable the mergingfirms to reduce the incremental cost of production” as more likely to be cognizable and verifiable thanother categories of efficiencies.48 Furthermore, in their influential paper, Farrell and Shapiro note thatclaimed economies of scale are more likely to be merger-specific when the necessary capital stock is noteasily “purchased through normal market transactions” – which seems to characterize spectrum.49 On the other hand, also as noted by Farrell and Shapiro, the larger the claimed efficiencies fromeconomies of scale, the more compelling is the argument that either or both firms have strong unilateralincentives to grow to reach the larger scale, and the only portion of the efficiencies specific to the merger isthe greater speed of attaining scale through merger rather than through internal growth (or through thepurchase of smaller competitors).50 It is not impossible to buy or trade for spectrum on the open market; 51nor is it unlikely that the FCC will make more spectrum available for mobile telephony use through futureauctions.52 Furthermore, other assets are complementary to spectrum, so that a provider moving upwardson its marginal cost curve for spectrum use may address this issue through other investments. 53 Again, thefaster the firm is currently moving up the cost curve, the more compelling the case for unilateralinvestments to complement the constrained input. As usual, buying a competitor is the cheaper andprivately preferred solution, but it may not be the welfare-maximizing one. All in all, this particular merger proposal seemed to founder on some implicit contradictions that maybe expected to cause difficulties for firms seeking to make claims for similarly “immense” efficiencies inthe future. First, is it really credible that an already very large firm, and/or a firm with an already largemarket share, is in a position of significant unexhausted production economies? Second, if that is the case,47 See, for example, Leslie M. Marx, Critical Issues in Competition in Communications Markets: Issues from a U.S.Perspective, presented at the 13th ACCC Regulatory Conference, Brisbane, Australia, July 27, 2012, available athttp://www.accc.gov.au/content/item.phtml?itemId=1065906&nodeId=ff03fa29e1f3c8fe21569cddf00f3f79&fn=Presentation%20by%20Leslie%20Marx.pdf.48 Guidelines at ¶10.49 Joseph Farrell and Carl Shapiro, Scale Economies and Synergies in Horizontal Merger Analysis, ANTITRUST L. J.68 (2001) 685, 693.50 Also the less credible is the contention of the merging firms that barriers to entry into the markets affected by themerger are small.51 Katy Oglethorpe, DOJ gives Verizon’s spectrum purchase conditional approval, GLOBAL COMP. REV., August 16,2012, http://www.globalcompetitionreview.com/news/article/32221/doj-gives-verizons-spectrum-purchase-conditional-approval/.52 FCC, “About auctions,” http://wireless.fcc.gov/auctions/default.htm?job=about_auctions.53 Sprint economists SBKMW discuss this point fairly extensively in their Declaration at ¶¶185-95. See also SueMarek, AT&T to expand LTE network to 300M POPs, deploy at least 40,000 small cells, FIERCEWIRELESS,November 7, 2012, http://www.fiercewireless.com/story/att-expand-lte-network-300m-pops-deploy-least-40000-small-cells/2012-11-07. 12
  13. 13. is it really credible that the firm cannot achieve such economies through organic growth – that theachievement of these economies is really specific to this merger? Or, stated otherwise, is it really crediblethat the economies may be achieved only through the firm’s purchase of the specific assets possessed bythe merger partner? Third, if that is the case, is it really credible that barriers to entry into the market areinsignificant? How can a much smaller firm compete on equal grounds with the super-efficient mergedfirm? And fourth, if that is the case, how likely is it that competition will force the new super-efficient firmto pass along its cost savings in the form of lower prices? Clearly it is not impossible for these conditions to be satisfied. However, they would seem to present asignificant challenge for firms claiming very large efficiencies to counterbalance significant losses ofcompetition from a merger. 13

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