Coase's view on (radio frequency) regulation

The FCC as a failing solution to the etheric bedlam offered Coase an excellent opportunity to expound his central message to the economists that would eventually laureate him with the Nobel Prize in 1991. Coase unfolded his seemingly ambiguous theoretical position for the first time in his 1937 paper. On the one hand, junior economist Coase held on to the tenet of his London-School-of-Economics professor Arnold Plant: ‘The normal economic system works itself’. (Coase, Reference Coase1937: 387). On the other, he specified that ‘the operation of the market costs something’, introducing the concept of transaction cost in economic theory (Coase, Reference Coase1937: 392). Transaction cost uncovers the need for institutions in economic life. Coase's 1959-paper actually was a reformulation of his 1937-paper, approaching the institutional dimension of economic life straightforwardly.

The question was this: why does etheric scarcity require government regulation, whereas, for other scarce means such as capital and land, the American economic system employed the price mechanism? Coase's analytical trouvaille was: ‘the real cause of the trouble was that no property rights were created in these scarce frequencies’ (Coase, Reference Coase1959: 14). The definition of frequency rights will render this hopelessly indiscriminate affair superfluous. Instead of the FCC, the highest bidder may decide on the use, enabled by the establishment of property rights.

The significance of the 1959-paper is broad. First of all, it is the focus on property rights as a central concept that deepened the insight in the actual working of the market. It floored the Pigovian approach to externalities, uncovering a fundamental omission in the mainstream microeconomic theory. Coase's property-rights solution of the frequency issue leads almost imperceptibly to restating the very theme of economics. A step by step recap may show this.

Generally, economic actors think of commodities in physical entities, acres of land, a bottle of wine, taking for granted the bundle of property rights these commodities entail in the economy (Coase, Reference Coase1988: 11). However, the nature of radio frequencies makes clear that transacting such a thing as the use of radio frequencies, and likewise any commodity or service, indispensably requires a well-specified definition of the bundle of rights concerned.

Consequently, the attention to property rights triggers attention to the notion of reciprocity. The establishment of a property right implies the assignment to someone and the exclusion of others. ‘All property rights interfere with the ability of people to use resources’ (Coase, Reference Coase1959: 27). It denotes a kind of reciprocity that becomes manifest in the economic transaction the assigned property right may invite to. It is this reciprocity that is obviously wanting in the Pigovian approach to externalities.

The Pigovian remedy transfers property rights without knowing the relative value of them. However, ‘the problem is to avoid the more serious harm’ (Coase, Reference Coase1959: 26). For instance, the harm to B inflicted by A, might exceed the benefit of A's harmful activity. Pigou did not see this reciprocity, and was unable to see it as he reasoned in the quantities and the prices of the Paretian optimum, formulated in marginal variables. Moreover, Pigou did not worry about the laborious nature of his remedy. Pigou and the Pigovians are not concerned about transaction costs, as the whole affair did not concern transactions at all.

The concept of transaction cost enabled Coase in his 1937-paper to demonstrate the role of institutions, e.g. in economics, the hierarchy of a firm. The 1959-paper presented an immediate introduction to the institutional dimension. The frequency issue brought on the concept of property rights; nota bene the institution without which economics is unthinkable. Together, the concepts of transaction cost and property rights, floored where the Pigovian ‘blackboard economics’ stands for; i.e. a world of choices concerning scarce means and alternative uses aligned with marginal optimum conditions. Coase opened the invisible economic inner world of institutions. It is a turn in economics, in particular revealed in Coase's innovative approach to externalities.

The property-rights perspective showed that there is no analytical difference between the right to use a resource without direct harm to others and the right to conduct operations in such a way as to produce direct harm to others. In each case something is denied to others: in one case, the use of a resource; in the other, the use of a mode of operation (Coase, Reference Coase1959: 26). This is the inference of the FCC-paper. Coase repeated the proposition presenting the new perspective on externalities as follows:

Well-defined property rights enable an efficient allocation of the use of radio frequencies to the highest bidders. The procedure will require minimal transaction cost and arbitrariness seems to be banned. It will result in a commercial broadcasting industry; a consequence of individual's primacy. However, this does not mean being back to square one as the application of Coase's recommendations in the UK case suggests.

The UK case

In this section, we provide information on the UK-case relevant for discussing how in the Coasean perspective the UK government should have acted in introducing private property rights and a market for these rights. Moreover, we provide information about the developments after the introduction of a market for radio spectrum licenses, notably with respect to the number of trades.

In 2001, the UK government commissioned Martin Cave to undertake a review of radio spectrum management in the UK. The ‘Cave Report’ as it became known (Cave, Reference Cave2002), recommended a policy of selective deregulation of spectrum use where possible and an increased reliance on the market rather than administrative systems. This was to be achieved by a two-pronged approach: the use of markets in the case of commercial use, and the continued reservation of spectrum for public service use, coupled with an administrative charge designed to ensure economy and efficiency of its use. Spectrum trading was expected to give incentives to firms to:

The Cave Report also recommended licencing based on access to spectrum defined by the parameters of frequency, geography and time rather than by type of apparatus. This would enable division and amalgamation of licences.

Secondary trading would enable prospective spectrum users to enter the wireless market and develop a service by purchasing a license they needed when required. The report strongly advocated the earliest and widest application of trading possible and to be introduced in a way that would minimize transaction costs while maintaining the integrity of the spectrum management regime. The licensees would be given the freedom to divide and partition their licences by frequency and geography for subsequent sale. The report cautioned that although a market-based approach might lead certain operators to gain and abuse dominance in the spectrum market or a ‘downstream’ market which uses spectrum as an input, this could be dealt with using competition law rules.Footnote ⁴ The Cave Report described the role of Ofcom, the UK national regulatory authority, as follows:

In the UK, the transfers of rights were regulated by the Wireless Telegraphy (Spectrum Trading) Regulations, 2004.Footnote ⁵ Trading in the rights is now permitted in six usage sectors: business radio, spectrum access, concurrent spectrum access, broadband fixed wireless access (scanning telemetry), fixed services and public wireless networks. Although Ofcom has stated publically that ‘a successful market needs information about whatever is being traded’, key details, such as price, are not made publicly available. Furthermore, a license trade is not distinguished from a license transfer between undertakings, as part of a firm acquisition or merger (Akalu and Arias, Reference Akalu and Arias2012, Akalu, Reference Akalu2014).

Although Ofcom has stated that there has been a clear upward trend in the number of transactions since trading began in 2004, the number of trades is still low relative to the number of potentially tradable licenses, as judged by Prof. Cave (see Sims, Reference Sims2008). The situation as of March 2013 is reflected in Table 1.

Table 1.

Number of licenses by category and number of trades between 2004 and 2013

*These are transfers between undertakings.

Source: Authors (based on Akalu, Reference Akalu2014; ECC, 2011; Ofcom, 2014).

Coase and the UK Case

According to a Coasean perspective, policy recommendation to governments considering the introduction of a market for radio spectrum licenses is first of all: assign well-defined property rights. Second, take into account the transaction costs of a fine-tuned property-rights definition and the information issues these entail. Third, reflect on actors’ rent-seeking behaviour in the industry, e.g. how to prevent the concentration of significant market power and the hoarding of spectrum usage rights. The important message from Coase is that the assignment of rights brings the rewarded applicant profitable opportunities. Subsequently, the private owner faces the checks and balances of the market, which will force him to efficient behaviour. The situational logic of a private market in spectrum usage rights will leave the actors no other option then to use the resource in the most efficient way. To allow this to happen, the situation should be designed and implemented according to Coase's ‘institutional economics’.

Because Coase is first and foremost interested in the efficient allocation of the scarce spectrum resource, in his perspective, the first question is about the initial assignment of the property rights. The way the assignment is done has large implications for the number of potential owners of licenses in the spectrum market and for the number of trades that one can expect. Key questions are: Was the auction well-designed and did it result in an efficient assignment?

The next question in the Coasean perspective concerns the design of the secondary market for trading spectrum licenses: Were the basic rules of ‘pure and perfect competition’, in terms of access, availability of information, anonymous interaction among participants and the homogeneity of the product, implemented such that prices will reflect scarcities? In the Coasean perspective, the costs of market transactions are of great interest. Hence, are public and private institutions created that minimize transaction costs when searching for partners to trade, to negotiate, to establish and execute contracts, to monitor and sanction afterward? Following the Coasean perspective, one would like to know why in the UK the prices are not made public. What is the impact on the availability of information and consequently on the transaction costs involved? Did specialized brokers emerge as envisaged?

If the answers to all these questions do not indicate any failure in the design of the initial assignment and in the design of the secondary market then the observation of a few trades can only mean that the initial allocation was efficient. The number of trades is not a relevant issue, only the possibility to trade is important. This fits well with the general claim of mainstream economics: if markets are well designed they reveal the subjective values of the participants; many trades can take place, but also a few or none; prices can strongly fluctuate, show trends or remain stable. These indicators do not say anything about a good or bad functioning market; the crux of the matter is to design the property rights well and to design the market to trade them well. Then the best outcome possible will be realized and the market will reveal this outcome.

Scarcity

Scarcity is the entry point for the economic discourse and the justification for the establishment of property rights. A property right engenders access as well as exclusion.

There is a physical limit to the use of the radio spectrum in terms of the information a radio communication channel of a specific bandwidth can carry (Shannon–Hartley Theorem). In practice, the scarcity is a function of the technology applied and the way the spectrum is governed. Within this context scarcity becomes tangible through the occurrence of harmful interference that results from conflicting transmitted signals or energy emissions. As such it is determined by place, time, the frequency used, the power of the transmitter and the selectivity and sensitivity of the receivers. Scarcity becomes apparent in areas of high usage, typically in urban areas. The expectations are that in the case of calamities public safety services have guaranteed spectrum access, citizens are able to use their cellular phones and broadcasters should be able to inform the public at large. Scarcity in spectrum is related to the most attractive frequency range, from 300 MHz to 3 GHz, the so-called sweet spot. Resolving the scarcity issues brings us back to the issue of common value and how to resolve conflicts in the realization of a set of common values simultaneously.

Sovereignty

In a Commons type of analysis attention would have to be paid to the role of the ‘sovereign’. Commons took sovereignty as the ‘monopolization of violence’ (Commons, Reference Commons1950: 74). It is the ‘sovereign’ that will decide disputes between conflicting parties and in doing so will command obedience.

As the custodian of the radio frequency spectrum, the nation state holds the power to allocate and assign rights to the use of the radio spectrum within its jurisdiction. In the initial assignment of rights, the rationing transaction, the state reflects its objectives and valuation of uses and users of the radio spectrum, typically distinguishing between private use (commercial and competitive) and public use (reserved and non-competitive). In the assignment, the states follow the ITU recommendations at the global level. At the regional level – in Europe – they follow the CEPT in its role of coordination the radio frequency use and ETSI in providing the wireless standards.Footnote ¹¹ Moreover, they follow the EC directives and guidelines for harmonization aimed at creating a European single market.

Since tradable licenses will essentially amount to a new form of property, the issue will become how control will be exercised over this property and over the new forms of governance that are being developed. Many of these will be private commercial initiatives aimed at responding to dynamic market conditions, including initiatives to create standards to realize economies of scale through interconnection of networks and interoperability of equipment. In the perspective of Commons, one should be very eager to explore what these expected developments would imply for the common value of spectrum.

Futurity

This element of economic theory forces the analysis into potential future developments: how do private actors that have to take decisions in the present perceive the future? How does an institutional change impact their valuation and how does it impact the barriers to entry and the introduction of new technologies? Economists ought to have theories about ‘futurity’.

In the Commons’ perspective, one would assume that the UK spectrum licenses have a value that is related to its expected scarcity, which is its economic futurity. This valuation will depend on the security of present expectations of future profits, investments and contracts. To illustrate: The UK 3G license award process occurred at the peak of the Internet/telecom bubble in 2000 and generated £22.5 billion or €650 per inhabitant. It was the highest level of proceeds in the 3G auction cycle in Europe, Germany followed with €613, the Netherlands with €171 and France €169 (Lennin and Paltridge, Reference Lennin and Paltridge2003; OECD, 2005).

In assessing the future value of spectrum rights, the frequency band is important in relation to the (new) type of use being considered, the amount of spectrum being assigned, the geographical coverage, the license period, as well as any potential restrictions in use. Moreover, the current and future level of competition are important in assessing future returns, as is any regulatory, political or economic uncertainty. This is all linked to the expected uptake and anticipated willingness to pay by end-users.

Custom

To understand the UK case and especially the developments after the introduction of trading, the economist should have a good understanding of formal and informal working rules, including custom. What are prevailing customs among the public and private actors, do the prevailing customs align with the common values and if not how to change them?

As an example of custom or industry practice, one should realize that any assignments of radio spectrum rights at the national level are typically preceded by many years of work within regulatory bodies, such as the ITU at global level and CEPT/ERCFootnote ¹² at the regional level, to coordinate the allocation of uses to specific spectrum bands. Moreover, many years of technology coordination of radio spectrum use in standardization bodies precede the deployment.

The process is typically top-down. With the introduction of markets at the national level, the question to be answered is whether markets should be assigned within the boundaries of radio spectrum allocations (as is the case in the UK) or across allocation boundaries; the allocations to be relaxed or removed at regional and global level as part of bottom-up reform initiatives? And as the role of markets increases, will private actors be able to effectively and timely coordinate the use across an increasingly larger part of the radio spectrum and across national and regional boundaries?

Efficiency

In the context of efficiency, it is important to recognize that wireless communications require compatibility and interoperability of the transmitters and receivers. This is important for national markets to function properly, but is as important on the regional and global level. Static efficiency is closely linked to dynamic efficiency. Moreover, allocative efficiency across countries in terms of spectrum rights (in terms of number of players and timing) is closely linked to productive efficiency in terms of availability and cost of infrastructure and terminal equipment.Footnote ¹³ The development of mobile systems in Europe illustrates the point of achieving economies of scale within a command and control regime.

The first generation of mobile equipment based on an open standard developed by the Nordic telecommunications administrations NMT-450Footnote ¹⁴ was introduced in 1981. The specification was made available – free of charge – to the equipment vendors. The stage was set for the broad deployment of first generation – 1G – mobile telephone systems. In the Netherlands, Belgium and Luxemburg the incumbent operators adopted the NMT-450 standard. However, national cellular standards were applied in Germany, France, the UK and Italy. These national standards did not provide for interoperability, hence, travelling abroad required a different handset in almost every country in Europe.

The potential of pan-European mobile communications was observed by the French PTT who convened a meeting with other PTTs in 1981 to explore the use of the 900 MHz band. This led to a working party created within CEPT: the Groupe de travail Spécial pour les service Mobiles (in short: GSM) to develop a specification. In 1984, the European Commission endorsed the project and it issued a directive for the launch of GSM by 1991, with a minimum set of services. In the fall of 1992, GSM was launched in 7 countries by 13 operators. (GSM Association, 2004; Manninen, Reference Manninen2002; Meurling and Jeans, Reference Meurling and Jeans1994). By the end of 2011, GSM had captured 75% of the global cellular market, with 4.5 billion users.

In contrast, the historical record shows that very rarely a fundamentally new wireless technology is turned into broad deployment by a single firm, probably Qualcomm and CDMA is the best known example (Lemstra et al., Reference Lemstra, Anker and Hayes2010a; Mock, Reference Mock2005). Within a license-exempt regime for short range devices (essentially a property rights regime at the level of the individual user), private actors have collaborated in the establishment of the IEEE 802.11 standard and the allocation of frequency bands, leading to the global success of Wi-Fi (Lemstra et al., Reference Lemstra, Hayes and Groenewegen2010b).

Assessing the developments after trading was introduced

In assessing the degree to which trades have occurred, insights into the properties of the ‘good’ being traded is important as well as the context in which the ‘good’ is used. Two examples of a first order assessment follow.

As the access to spectrum is complementary to the use of a communications network and devices in order for a service to be provided, the question whether the rights to access the spectrum can be traded meaningfully without considering the related infrastructure and device assets becomes important. This linkage suggests that separating the license from the infrastructure and selling it separately may reduce the value of the infrastructure significantly (possibly to scrap value). This may explain why for PWN licenses no trades have occurred, only transfers between undertakings.

If the assignment of the license has been on the basis of first-come-first-served, as was the case for business radio, it implies there was no scarcity in the related frequency band. A license can thus be acquired through an application to the regulatory authority or through trade. The price in the market will unlikely exceed the price to be paid through the administrative process. A difference in transaction costs may point to the most likely course of events; the administrative process is well defined, while information on licenses in the market may be lacking. A trade may benefit the seller in terms of recuperating any residual value of the license. An increase in the trade of business radio licenses may point to an increase in scarcity.

Dual role of the market

As over time the use of the radio spectrum expanded it has become apparent that not all common values could be realized at the same time without conflict. In resolving conflicts in the realization of common values, the role of economic valuation of radio spectrum use becomes increasingly important.

In the radio governance regime, as it has evolved from 1927, the valuation of radio spectrum use has become a two-step process of rationing transactions. First in terms of the allocation of use at global and regional level and second in the assignment of users at the national level. The allocation and assignment processes are executed by government representatives and/or agencies and the influence of the (potential) users is limited to submitting arguments and pleadings. Moreover, the value of use remains implicit. The only way of valuation, which makes the value explicit in monetary terms, is through the application of markets and the price mechanism.

Conflicts in realizing common value typically relate to scarcity of the resources required. Scarcity being the entry point for the economic discourse, the market is considered the instrument to resolve scarcity issues through the price mechanism.

Hence, approaching the governance of radio spectrum from two perspectives, following Coase and Commons, respectively, leads to the market as a tool for two different purposes: to resolve interference issues and to achieve efficiency on one hand and to solve valuation and scarcity issues on the other.

The two perspectives point to the market as an alternative for the existing command and control governance regime. Markets can be introduced top-down and bottom-up, i.e. starting with allocation process or starting with the assignment process. The more feasible approach to realizing changes in a global and entrenched governance regime is bottom-up, within the national scope of assigning usage rights. This was the approach followed by the UK government.