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«The Effect of Incumbent Bidding in Set-Aside Auctions: An Analysis of Prices in the Closed and Open Segments of FCC Auction 35 Peter Cramton ...»

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Telecommunications Policy, 32, 273-290, 2008.

The Effect of Incumbent Bidding in Set-Aside Auctions:

An Analysis of Prices in the Closed and Open Segments

of FCC Auction 35

Peter Cramton

University of Maryland

Allan T. Ingraham

Criterion Auctions

Hal J. Singer

Criterion Economics, L.L.C.

The Effect of Incumbent Bidding in Set-Aside Auctions:

An Analysis of Prices in the Closed and Open Segments

of FCC Auction 35

This paper examines the impact of an incumbent carrier’s participation in two simultaneously conducted auctions:

one set-aside for non-incumbents and one open to all carriers. This paper estimates the extent to which prices in the closed auction were inflated by the participation of incumbents. This paper also estimates what prices would have been in the open auction had incumbents been excluded from bidding in the closed. It is found that an incumbent’s participation in the closed auction through a front, Alaska Native, enabled it to win more licenses at lower prices in FCC Auction 35. In contrast, non-incumbents won fewer licenses and paid more for what they won. The econometric techniques employed here to estimate prices in a “but for” world could be replicated in future damage analysis.

Finally, this paper suggests an alternative method of screening bidders seeking access to set-aside auctions that would be consistent with the FCC’s goal of promoting competition in the wireless industry.

1. INTRODUCTION The Federal Communications Commission’s (FCC’s) re-auction of the C- and F-block licenses (Auction 35) represents a rare natural experiment that economists, and game-theorists in particular, can analyze. Beginning in December 2000, the FCC conducted two simultaneous auctions of largely substitutable goods—radio spectrum licenses covering similar U.S. territories.

The FCC first auctioned the majority of those licenses, commonly known as the “NextWave licenses,” in 1996, but reclaimed the licenses after NextWave and other wireless operators failed to meet their payment obligations from the prior auctions.1 This new auction was conducted while the FCC and NextWave were in litigation over the license reclamation.

NextWave was one of the first firms to take advantage of the FCC’s set-aside program—the original FCC auction in which NextWave obtained the licenses was reserved for small entrepreneurial firms, called “designated entities” (DEs). To encourage entry of new wireless operators in 2000, the FCC again reserved certain portions of the spectrum (the “closed” auction) for entrepreneurial firms. In particular, the FCC prevented the participation of any firm in the closed auction that was “controlled” by a firm with assets in excess of $500 million or annual revenues in excess of $125 million (FCC Notice, October 5, 2000). This control standard was intended to promote diversity among wireless carriers and competition after the auction, while allowing small carriers to gain improved access to investment capital from larger telecommunications firms. However, under this control standard, certain incumbent carriers gained access to the closed auction by creating front companies. For example, AT&T Wireless, a firm with assets of $43.0 billion (86 times the FCC’s limit) and operating revenues of $6.6 billion (53 times the FCC’s limit) as of June 2001,2 gained access to the closed auction through the creation of a bidding front under the name “Alaska Native.”3 According to Alaska Native’s bidding application filed at the FCC in November 2000, AT&T Wireless owned 38.2 percent of the equity of Alaska Native plus debt that was convertible to another 41.2 percent of the company’s equity.4 Alaska Native was the dominant bidder in the closed auction. It won approximately 36 percent of the set-aside licenses on a population-weighted basis, and approximately 50 percent of the set-aside licenses on a value-weighted basis.5 However, despite winning the auction, many high bidders did not immediately receive licenses because the NextWave litigation was ongoing. On August 12, 2002, a group of scholars specializing in telecommunications wrote an open letter to FCC Chairman Michael K. Powell, contesting the binding nature of the auction bids. Despite the fact that FCC could not deliver the purchased spectrum, the winning bidders had to treat the obligations as contingent liabilities, raising the carriers’ costs of capital and impairing credit ratings. The writers therefore advised the FCC to, “cancel bids made in, or permit winning bidders to opt out of, Auction 35.” By December 2002, many months had passed since the June 2001 D.C. Circuit Court of Appeals decision which ruled in favor of NextWave, and the Supreme Court was expected to announce their decision on the appeal of the Circuit’s decision. Verizon pushed a multi-front litigation and legislation strategy to be released from the auction bids, which culminated in the FCC offering an Opt Out plan for all Auction 35 winners. Then, in January 2003, the Supreme Court rejected the FCC’s reclamation of the licenses, ruling that while a company is reorganizing under bankruptcy protection, as was NextWave, federal bankruptcy law protects it from dismemberment by regulatory agencies, just as federal bankruptcy law protects a bankrupt company from ordinary creditors. NextWave eventually sold all their licenses in April 2005 to Verizon for $3 billion. Although bids for the majority of licenses let at Auction 35 were eventually cancelled, an analysis of those bids is still valid since those bids represent intent by wireless carriers to lease that spectrum at the associated bid prices. Furthermore, an analysis of Auction 35 bidding is useful in avoiding future problems with the DE program.





In the Advanced Wireless Services (AWS) auction that concluded on September 18, 2006, the FCC moved to remedy past failures of the designated entity program (DE program). In particular, statements by Commissioners Michael J. Copps in response to an Order on Reconsideration for Service Rules for AWS spectrum in the 1.7 GHz and 2.1 GHz Bands indicated the FCC would move to ensure that DE program was not exploited by large wireless carriers. Copps stated, “The DE program is designed to create opportunities for smaller carriers to obtain the spectrum resources needed to bring new services to consumers... Some entities cast themselves as small companies to qualify for auction discounts, having already entered into agreements to lease the spectrum rights they win to industry giants that themselves do not qualify for the discount.” These comments, which followed the AWS-1 Order on Reconsideration, echoed the twin regulatory goals of providing additional opportunities for smaller and rural wireless carriers and enhancing flexibility for potential licensees. The Small Entity Compliance Guide for the first AWS auction, which the FCC published on August 9, 2006, laid out the key changes that were

subsequently made:

The new rules both limit the award of designated entity benefits if any applicant or licensee has a “material relationship” created by certain agreements with one or more entities for the lease or resale of its spectrum capacity, and set out new standards for the payment of unjust enrichment See 47 C.F.R. §§ 1.2110(b)(3)(iv)(A) – (B) (designated entities) and 1.2111 (unjust enrichment).

Under these amended rules, larger companies have a more difficult time creating fronts to take part in set-aside auctions.

The changes were also interpreted by Copps, who stated on April 25, 2006, “I am pleased that by strengthening our unjust enrichment rules we take away the incentives for speculators to try to masquerade as legitimate DEs. Under our new rules, bidders who benefit from the 25 percent discount must forfeit that discount if they then turn around and sell some or all of their rights to someone else… I am also pleased that we commit to thoroughly review the application and all relevant documents for each and every winning bidder claiming DE status. Additionally, we pledge to audit every DE at least once during the initial license term.” Ayres and Cramton (1996) demonstrate how set-asides and bidding credits impact competition and prices in auctions. If only weaker bidders (non-incumbents) can bid on the setaside licenses, the impact of the set-aside auction is to lower prices for the weaker bidders and raise prices for the stronger bidders (incumbents). This creates an incentive for incumbents to participate in the set-aside (closed) auction through a front.

Csirik (2002) finds that revenues from FCC Auction 35 actually rose as a result of the discounted pricing. While some licenses are given out cheap, Csirik argues that the extra that Verizon had to pay as a result was the dominant effect of the discount regime. Furthermore, Csirik finds that overall the DE rules had little effect on the allocation of the biggest licenses between the various participants. In contrast to Csirik, who simulates a world without DE status at all, this paper isolates the effects on the auction of the AT&T’s participation through Native Alaska. This paper focuses on outcomes in a world with DE status where DE status cannot be abused, rather than a world completely devoid of DE status.

Bajari and Fox (2005) find that simultaneous ascending auctions for spectrum may allow the market to sort for geographic complementarities. However, the auction design might also result in an inefficient equilibrium, due to implicit collusion. This paper builds on that research by extending analysis to auctions where some participants may not bid on all offerings, and where different participants must bid on the same products at different prices.

This paper attempts to quantify (1) the extent to which prices in the closed auction were inflated by the participation of Alaska Native, and (2) the extent to which prices in the open auction were deflated by the lack of participation by incumbent carriers. It is found that the use of bidding fronts significantly raised prices in the closed auction and significantly lowered prices in the open auction. The paper then reviews the FCC’s control standard in Auction 35 and compares it to the control standard used in the first AWS auction, which was completed in September 2006.

The study finds that the revised control standard the FCC used during the AWS auction is superior to the control standard used for Auction 35 and is more likely to improve the viability of small and rural wireless carriers to the extent that the FCC believes that small carriers are necessary for a competitive wireless market in the United States.

The paper is organized as follows: Part II provides a brief introduction to the FCC’s set-aside program and explains how at least one company exploited the FCC’s control standards.6 In Part III, the results of Auction 35 are summarized. This paper examines the three primary channels in which Alaska Native’s participation adversely affected legitimate entrepreneurs in the closed auction. First, Alaska Native obtained licenses that would have otherwise been awarded to entrepreneurs. Second, Alaska Native’s bids increased the prices that legitimate entrepreneurs paid for fourteen closed licenses on which Alaska Native was the last bidder to drop out. Third, by driving up prices in first-tier markets, Alaska Native forced value-seeking bidders to turn their attention towards second-tier markets, thereby inflating prices in markets where Alaska Native never submitted a bid.

Part IV simulates prices in a but-for world in which AT&T competed against other incumbent carriers in the open auction. In the closed auction, the demand for spectrum would shift in, thereby generating lower prices. In the open auction, the demand for spectrum would shift out, and higher prices would result. Econometric techniques are used to construct the demand curves in the open and closed auctions under the assumption that AT&T was allowed to bid only in the open auction. The intersection of the supply curve and the reconstructed demand curves represent the predicted prices.

The paper concludes with a brief analysis of the FCC’s screening process for entrepreneurs.

Although the FCC’s definition of control could promote an efficient auction, it could sacrifice diversity and competition after the auction. The FCC’s understanding of control is not grounded in economic thought. This paper suggests that sophisticated entities such as NextWave and AT&T render the FCC’s affirmative action program ineffective. Moreover, the FCC appears to be incapable (or unwilling) to enforce the Congressional mandate of diversity in the airwaves.

2. THE FCC’S SET-ASIDE PROGRAM AND THE CREATION OF BIDDING FRONTS

In this Part, this paper introduces the FCC’s set-aside program in Auction 35 and explains how certain savvy carriers exploited the FCC’s affirmative action policies.

2.1. THE PARTITIONING OF THE NEXTWAVE LICENSES BY THE FCC

After years of administering a duopoly in the provision of cellular wireless service, the FCC allocated additional spectrum for personal communications services (PCS) to promote greater competition in the wireless telecommunications industry. Beginning in the mid-1990s, the Commission defined geographic service areas, apportioned six additional licenses per service area, and auctioned those licenses to wireless providers. Those licenses were called the A, B, C, D, E, and F blocks. Notwithstanding the appropriate classification of specialized mobile radio (SMR) providers such as Nextel,7 under the Commission’s licensing arrangement, the maximum number of unique personal communication services (PCS) providers that could obtain spectrum at auction in a given license area was six—that is, one distinct carrier per block. However, PCS licenses can be disaggregated. Were a PCS provider to sell only a portion of its spectrum purchased at auction, the number of providers in a given license area could, in theory, exceed six.



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