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INTERNATIONAL SCHOOL OF MANAGEMENT
   MASTER OF SCIENCE PROGRAMME




           Nerijus Dumbrava
          Student ID: 0786324




          MASTER'S THESIS
        TITLE OF THE THESIS




                                       Supervisor
                                Nerijus Pačėsa 2005 _    _


                                       Supervisor
                                Lars Thue       2005 _   _


                                        Reviewer
                                       2005 _    _


                                        Reviewer
                                       2005 _    _




            VILNIUS, 2005
CONTENTS


List of Figures                                                2
List of Tables                                                 3
Introduction                                                   4
1. Overview of 1G, 2G, 2.5G, 3G mobile communication systems   7
1.1. First generation (1G)                                     7
1.2. Second generation (2G)                                    9
1.3. Intermediary generation (2.5G)                            11
1.4 Third generation (3G)                                      11
1.5 1G, 2G, 2.5G, 3G compared                                  13
1.6 1G, 2G, 3G in Lithuania                                    14
2. Internal - structural factors influencing growth            15
2.1 Network effect                                             15
2.1.1 Michael L. Katz and Carl Shapiro                         15
2.1.2 Stan Liebowitz and Steve Margolis                        20
2.1.3 Other authors                                            21
2.2 Diffusion of innovations                                   23
2.2.1 Everett M. Rogers                                        23
2.2.2 Bass model                                               25
3. External – regulation factors influencing growth            29
3.1 Methods of allocation of scarce resources                  29
3.2 Role of regulation                                         32
3.3 Alternative approach                                       34
4. Empirical analysis                                          37
4.1 Example of empirical research                              37
4.1.1 Massini’s research                                       37
4.1.2 Botelho research                                         40
4.2 Empirical data analysis                                    43
4.2.1 Correlation analysis                                     45
4.2.2 Regression analysis                                      48
4.2.3 Curve estimation                                         53
Conclusion                                                     58
References                                                     60



                                                                    1
LIST OF FIGURES


Figure 4.1   Scatter diagram for mobile phone subscribers and GDP
Figure 4.2   Scatter diagram for mobile phone subscribers and average income.
Figure 4.3   Scatter diagram for mobile phone subscribers and fixed line subscribers
Figure 4.4   Curve fit analysis for Linear, Quadratic, Cubic and Power functions
Figure 4.5   Curve fit analysis for Compound, S, Growth, Exponential and Logistics
             functions




                                                                                       2
LIST OF TABLES


Table 1.1    Table 1.1 features of 1.5 1G, 2G, 2.5G, 3G mobile communication generation
             systems
Table 4.1    Cumulative data of mobile phone and fixed line subscribers.
Table 4.2.   Economical variables
Table 4.3    Correlation. Number of mobile phone subscribers and GDP.
Table 4.4    Correlation. Number of mobile phone subscribers and average income
Table 4.5    Correlation. Number of mobile phone subscribers and fixed subscribers
Table 4.6    Regression coefficients. Mobile phone subscribers and fixed line subscribers
Table 4.7    Regression characteristics. Mobile phone subscribers and fixed line subscribers
Table 4.8    Regression coefficients. Mobile phone subscribers and GDP
Table 4.9    Regression characteristics. Mobile phone subscribers and GDP.
Table 4.10   Regression coefficients. Mobile phone subscribers and average income
Table 4.11   Regression characteristics. Mobile phone subscribers and average income.
Table 4.12   Multiple regression coefficients. Mobile phone subscribers, fixed line subscribers
             and GDP.
Table 4.13   Multiple regression characteristics. Mobile phone subscribers, fixed line
             subscribers and GDP.
Table 4.14   .Multiple    regression coefficients. Mobile phone subscribers, fixed line
             subscribers and average income.
Table 4.15   Multiple regression characteristics. Mobile phone subscribers, fixed line
             subscribers and average income.
Table 4.16   Time series functions results.
Table 4.17   Estimation results of the exponential model




                                                                                               3
INTRODUCTION
Mobile communication is one of the most exciting technological developments of last decade.
No segment of any other industry has seen growth that happened in mobile communications.
From relatively modest start, the last 15 years where an explosion in the number of mobile
communications users. Starting from early introduction in 1990, number mobile telephone
subscription has doubled globally every 20 months. Starting from an 11 million subscriber
and an average penetration of 1% at 1990, the mobile communications industry now provides
services to 1,404 billion subscribers (International Telecommunication Union, 2003). As the
number of mobile subscribers in some countries is already overtaking fixed line subscribers
and reaching saturation level higher than 100%, it looks that mobile communication is
becoming primary mean of voice communication transmission However it appears, that
growth is likely to continue in the future taking even more interesting forms after the
introduction of technically advanced mobile cellular networks. This master thesis is intended
to examine the growth of mobile telephony and the factors that affect this growth.


Varying explanations of the growth factors can be found in the vast research literature of the
subject. Gary Madden, Grant Coble-Neal, Brian Dalzell (2004) suggest that one of the
reasons of such impressive growth over last decade could be market situation itself, because
the situation in mobile telecommunication sector from the early start was very different than
in the sector of traditional fixed line telecommunication. Authors remark that “Entry of
mobile providers into former monopoly markets ensured the evolution of a more competitive
environment.” From the very first mobile operators where operating in very competitive
environment, because usually in most countries at least two service providers where issued
with the licenses. That’s is why operators had to employ the strategies based on high
customers satisfaction: developing pricing packages to differentiate themselves from their
competitors, isolate market segments and target specific customer groups and geographic
regions


Jha and Majumdar (1999) have find out that mobile telephony penetration is varying
considerably amongst different countries depending to their gross domestic product (GDP).
Authors insist that bigger economical success translates into an superior demand for mobile
telecommunications services.




                                                                                            4
Gruber, Verboven (2001) notice that growth in mobile telephony might be affected by such
regulatory influences as the timing and number of licenses issued the method which is used to
grant the licenses, timing and manner of technological standardization.
However Erik Bohlin, Stanford L. Levin, Nakil Sung in the editorial of Special Issue on
Growth in Mobile Communications of Telecommunications Policy remark that “As is widely
recognized, accurately predicting the evolution of demand for new applications of technology
has eluded experts again and again. The history of mobile communications has been
characterized by underestimation of overall demand, overestimation of the potential of certain
applications (such as WAP), and the failure to foresee the popularity of others (such as
SMS).”


But the authors also add that complicatedness of forecasting does not necessarily mean that
various interest parties in the mobile communications field cannot impact developments by
creating environment for expansion, meaning that it main concern           should be put on
identifying and removing concrete barriers to continues growth. Balance should be found
between the requirements of consumers and demands businesses, the availability of
infrastructure and development of services, the financial equilibrium of operators, equipment
developers and other players in the mobile wireless area and the control employed by various
regulatory bodies.


Development of technologies ads one more interesting feature to the picture – services of data
transmission over mobile devices under 2.5G and 3G systems are already offered in some
markets. Already today there are many prediction and different opinions how these systems
should work, how their services should be priced and how consumers will react. Author of
master thesis also intends to touch this topic from theoretical where it is applicable,
addressing the challenges that will appear then the technological generation will change.


The thesis is organized as follow:
Section 1 is addressing technical issues related to the evolution of mobile communication
networks. It is intended to provide information about standards, generations, and timeline of
the evolution until current date and brief overview of mobile communication networks
development in Lithuania.




                                                                                            5
Section 2 provides discusses of relevant theoretical concepts from theory of economics of
innovations literature. To aid this discussion two most relevant subjects where chosen and
will be addressed:
   1. Network effect
   2. Diffusion of technological innovation


Mentioned concepts are studied having in mind their impact on researched topic thus linking
some of the researcher’s theoretical findings with practical examples from mobile
communication industry. Also these findings and concepts will be used in empirical part of
the research.


Section 3 will be used to address the role of state regulation by reviewing relevant researches
mainly about auctions of frequency distribution.


Section 4 concludes the paper by performing empirical research of growth factors of
Lithuanian mobile communication market. Existing researches on similar topic will be
reviewed in this section as well.
General focus research question: How has mobile communication industry developed to
current stage? Which factors and how influenced growth of mobile subscribers?
Author assumes that following research questions with corresponding objectives should be
addressed in his research:


Research question                            Research objective
   1. How has mobile communication              1.   To overview creation, main
       developed till now?                           principles and development of
                                                     GSM standard
   2. What implications, concepts and           2.   Examine        the       theoretical
       ideas does literature provide about           concepts of network effect and
       the possible reasons for growth               diffusion     of     technological
       mobile communication?                         innovation and find possible
                                                     links with the growth.
   3. What is the current role of market        3.   Overview       the       researches
       regulating bodies in fostering or             examining role of regulation and
       decreasing the growth?                        methods of regulation.



                                                                                             6
4.   Compare quantitative analysis
4. How main factors driving mobile        results.
   communication growth can be
   captured?




                                                                          7
1. Overview of 1G, 2G, 2.5G, 3G mobile communication
   systems

Before deeply analyzing driving forces of mobile communication development and its current
state, it is appropriate to review mobile communication technical development timeline, not
forgetting first and second generation systems. Like in most information technologies,
advances in mobile communications occur through a process of gradual evolutionary
development and the “occasional quantum-leap forward” (Clint Smith, 2001) periods. This
development is also characterized by term “hype cycle” by Gartner researchers1. That’s why it
is important to review development of mobile communication systems and try to observe
patterns of the possible past hype cycles, which might be a useful tool for the predictions and
forecasts about upcoming generation of mobile communication systems. Also before
analyzing such a complex and dynamic industry as mobile communication, it is important to
have some knowledge about basic technical details to better understand what is the
environment of the industry in which decisions are made.

      1.1.          First generation (1G)
Most of researchers, analyzing development of mobile communications systems, mention
USA as a place, where mobile communication technologies where born. First successful
implementation of the trial system was conducted in Chicago in 1978. The system was based
on technology called Advanced Mobile Phone Service (AMPS) and was operating at 800MHz
frequency. Commercial launch of this system was delayed and took place only in 1983.


However other countries were also making significant progress. Japan has launched a
commercial mobile communication system in 1979. System was based on the same Advanced
Mobile Phone Service platform which was tried in the USA in 1979. In 1981 the first
European mobile communication system was launched in Norway, Sweden, Denmark, and
Finland simultaneously. This system used a technology known as Nordic Mobile Telephony
(NMT) and was operating in the 450MHz band and became known as NMT-450. Later
version of the system was working in 900MHz band and was named NMT-900. System was
widely recognized as a successful project and later was installed throughout Europe, Asia, and
Australia.



1
    http://www4.gartner.com/pages/story.php.id.8795.s.8.jsp



                                                                                             8
Britain introduced at that time has chosen to adopt its own technology which was called Total
Access Communications System (TACS) and took place in 1985. Actually TACS was
upgraded version of AMPS, which was installed in USA and Japan.


In a few years time many other developed countries followed along joining the growing
community of mobile communications users, and soon mobile communications services
spread across the continents. During that time several other technologies were developed, but
AMPS, TACS NMT450 and NMT900 were the most successful and most widely adapted
technologies. Some of these systems are still in service even today. As (Collins, 2002) writes
“First-generation systems experienced success far greater than anyone had expected.”


But every success has its own limits. As the number of subscribers grew rapidly, they
exceeded potential capabilities of the systems, especially in the highly populated areas. Due to
specific architecture of the systems, it was already impossible to assure good quality of the
service and it was clear that actions should be taken immediately. This lead to the
development of second generation systems (2G).

   1.2.        Second generation (2G)
Year 1982 could be called a virtual starting point for the development of second generation
system, because in this year the Conference on European Posts and Telecommunications
(CEPT) embarked on developing new generation mobile communication system by
establishing a group called Group Spéciale Mobile (GSM, which later become an acronym for
second generation standard). After conducting an early technical work of the new digital
standard, work was overtaken by the newly created European Telecommunications Standards
Institute (ETSI) in 1989. ETSI finalized the first set of technical specifications giving the
same name of an earlier standard developer’s group– GSM.


The first functioning GSM network was set up in 1991, followed by several more launched in
1992. Also international roaming between the various networks soon followed. GSM was
regarded as hugely successful project and within few years almost all countries in Europe
between 1992 and 1996 set up GSM service, followed by countries in other continents. It
became evident that GSM will be more than just a European project - it was fast becoming
global, by changing the meaning of GSM letters to “Global System for Mobile
communications”




                                                                                              9
Consequently, the letters GSM have taken on a new meaning—Global System for Mobile
communications.
After few years one more important enhancement followed. Originally, GSM was designed
to operate to use 900MHz band, but to increase network capacity 1800MHz band was added
to the standard, called DCS1800 since which function simultaneously with the old frequency.
New sets of handsets where developed to support both frequencies. Nowadays most handsets
support also 1900 MHz frequency which is used for GSM in North America.
(Collins, 2002) mentions following benefits of 2G systems over 1G:
   1. Increased capacity over analog technology
   2. Reduced capital infrastructure costs
   3. Reduced the capital per subscriber cost
   4. Reduced cellular fraud
   5. Improved features
   6. Encryption
Most of the mentioned points directly benefit operator of the wireless system, but benefits
which users receive can also be observed:
   1. Lower service cost (due to reduced capital infrastructure costs and increased capacity
       of the network)
   2. Better voice quality, higher success of connection
   3. Additional features, new services (SMS, international roaming, sim card options, data
       transmission)
Many reasons for the rapid growth of second generation mobile communication (most of
these reasons will be addressed later in this thesis), but one important detail should be
mentioned above all of them. GSM was highly technically advanced technology (and still is),
because system design was made from the scratch without providing backward compatibility
with existing analogue systems. This results in following:
   1. System offers much mores advanced technological features, and is not connected to
       previous generation analogue technology by any means.
   2. Network operators are encouraged to build new networks as fast as possible because
       there is no backward compatibility.

   1.3.        Intermediary generation (2.5G)
2.5G could be called an intermediate mobile communication generation linking existing 2G
with 3G which is still under development. 2.5G basically is the method by which existing
cellular operators are migrating into the next generation wireless technology, which is



                                                                                         10
extensively specified the International Mobile Telecommunications-2000 (IMT-2000)
specification. For the implementation of 2.5G, there is no need to build totally new network,
because services are provided by upgrading current 2G equipment. This means that 2.5G
offers a backward compatibility which is extremely important having in mind huge
investment which will be required to set up 3G networks.
Following platforms are currently used in 2.5G systems:


• General Packet Radio Service (GPRS)/ High Speed Circuit Switched
Data (HSCSD)
• Enhanced Data Rates for Global Evolution (EDGE)


2.5G gives the wireless operators a possibility to provide digital high speed data transmission
services prior to the availability of 3G platforms. Providing 2.5 services, before 3G is very
beneficial to the operator:
   1. They can research customers needs
   2. They can develop various pricing schemes
   3. They have time to “educate” the customer about services which high data transmission
       technology provides
On the other side, (Collins, 2002) mentions following challenges for the operators engaging in
providing 2.5G services:
1. No one specific standard chosen for transition.
2. The overlay approach
3. The introduction of packet data services
4. The new user devices required
5. New modifications to existing infrastructure



1.4 Third generation (3G)
The demand for the next generation mobile communications technology became observable
during the period of rapid development and usage of networking technologies in the 90’s,
especially internet. Users soon realized that presence of a constant high speed connection
enables them to perform variety of different activities which prior where hardly possible or
even imaginative. Adding feature of mobility to the high speed access point would widen the
possibilities of high speed data transmission services even more.




                                                                                            11
Recognizing that fact, The International Telecommunications Union (ITU) in the 1990’s
launch the initiative called Future Public Land Mobile Telecommunications Systems
(FPLMTS) which was meant to prepare recommendation for the next generation mobile
communication systems. In 1997 ITU presented the recommendations under the name
“International Mobile Telecommunications—2000” (IMT-2000) which gave general direction
for the development of 3G mobile communication systems.
The IMT-2000 recommendations were intended to be unifying specification, enabling mobile
high-speed data services using one or several radio channels based fixed network for
providing the services under following conditions:
   1. Global standard
   2. Compatibility of services within IMT-2000 and other fixed networks
   3. High quality
   4. Worldwide common frequency band
   5. Small terminals for worldwide use
   6. Worldwide roaming capability
   7. Multimedia application services and terminals
   8. Flexibility for evolution to the next generation of wireless systems
   9. 2Ghz operating band
   10. High-speed packet data rates:
           a. 2 Mbps for fixed environment
           b. 384 Mbps for pedestrian
           c. 144 Kbps for vehicular traffic


As these where only general recommendation, ITU announced that it is open for the
submission of technical 3G implementation proposals. After these proposal where submitted,
5 technologies for terrestrial service where announced:
• Wideband CDMA (WCDMA)
• CDMA 2000 (an evolution of IS-95 CDMA)
• TD-SCDMA (time division-synchronous CDMA)
• UWC-136 (an evolution of IS-136)
• DECT




                                                                                       12
1.5 1G, 2G, 2.5G, 3G compared

Following table summarizes all mobile communication generation systems features,
standards, specifications.
Table 1.1 features of 1.5 1G, 2G, 2.5G, 3G mobile communication generation systems
Generation         Standards         Features                      Speed          Band
                                     Analogue voice service,                      300MHz        -
1G                 AMPS
                                     No data service                              600MHz
                                     Digital voice service;
                                     Low        speed       data
                                     transmission;
                   CDMA,TDMA,        Enhanced            calling 9.6K - 14.4K 600MHz            -
2G
                   GSM,PDC           features, caller ID;          bit/sec        1.8GHz
                                     Voice mail;
                                     Short messages;
                                     Global roaming
                                     Phone calls/fax;
                                     Send/receive       medium
                                     size email messages;
                   GPRS,     EDGE,
2.5G                                 Web browsing;                 64-144kb/sec
                   HSCSD,
                                     Navigation/maps;
                                     New updates;
                                     Multimedia messages                          1.5GHz        -
                                     Send/receive large email                     3GHz
                   WCDMA,            messages;
                   CDMA2000,         High-speed Web;
                                                                   144kb/sec-
3G                 TD-SCDMA,         Navigation/maps;
                                                                   2mb/sec
                   UWC-136,          Videoconferencing;
                   DECT              TV streaming;
                                     Electronic agenda




                                                                                           13
1.6 1G, 2G, 3G in Lithuania

First 1G generation mobile communication NMT-450 licence in Lithuania was issued
1992.06.04 by Lithuanian Communication and Transportation Ministry to the joint stock
company of Lithaunia and Luxemburg „Comliet“. Licence was issiued for 10 years period for
the price 884,000LTL. For the next 3 yeras „Comliet“ was leading mobile communication
operator in Lithuania with network covering about 80% of state territory. However with the
introduction of GSM technology it‘s share started to decilne significantly and in year 2000
„Comliet“ was acuired by local fixed telephony monopolis „Lietuvos Telekomas“. Currently
„Lietuvos Telekomas“ operates „Comliet“ as a fixed line telephony substitution provider,
where due to infavourable conditions is not possible to have traditional fixed line telephony.


First 2G mobile communication GSM DCS 900 licence in Lithuania was issued 1994.10.25
by Lithuanian Communication and Transportation Ministry to the Joint Stock Company
„Litcom“ which was later renamed to „Omnitel“. Currently „Omnitel“ is leadind mobile
communication network operator.


Second 2G mobile communication           GSM DCS 900 licence in Lithuania was issued
1995.05.09 to the Joint Stock Company „Mobilios telekomunikacijos“ which was later
renamed to „Bitė GSM“. Currently „Bitė GSM“ is one of the 3 mobile communication
operators in Lithuania with market share...


Due to vast network expansion and excessive number of subscribers growth „Omnitel“ and
„Bite GSM“ in 1997 requested second GSM DCS 900 licence. The where where issued with
the second licence on 1997.10.31. Each of the licences was issued for 10 years with fee
884,000LTL.
1998.02.23 proposed a tender (based on „beauty contest“ model which wil be examined with
more details later in the master thesis) for GSM DCS-1800 licence.1998.09.23 thee winners
where anounced: „Omnitel“ , „Bite GSM“ , „Levi and Kuto“. Joint Stock Company „Levi and
Kuto“ was later renamed to Tele-2. Tele-2 currently is second bigest mobile communication
network operator in Lithuania with market share.. 2000.12.29 „Tele-2“ was issued with the
DSC 900 licence. All mentioned licences tradionaly issued for 10 years period for 884,00LTL
fee. 3G licences in Lithuania are currently not issued.



                                                                                           14
2. Internal - structural factors influencing growth

In the following section various sources of network effect literature are summarized. For the
master thesis two main groups of authors where chosen: traditionalists, which started
developing network effect concepts in the 5th – 6th decade of the 20th centaury and few
relatively young and modern authors from the 9th decade of 20th centaury who are currently
trying to renew and supplement traditional concepts.

2.1 Network effect

2.1.1 Michael L. Katz and Carl Shapiro

It seems rather logical to start analyzing and reviewing literature on network effect from the
mostly quoted paper of this subject – “Network externalities, competition, and compatibility”
by Michael L. Katz and Carl Shapiro. This was one of the first papers which described
network effect in a fashion which is commonly used today. Katz & Shapiro (1985) observe
that “there are many products for which the utility that a user derives from consumption of the
good increases with the number of other agent consuming that good”. Authors of the paper
were one of the first to give reason for positive consumption externalities arising in the
network. In the following section author of the master thesis intends to relate these reasons
with the main topic of the thesis:

1) Direct physical effect which increasing number of purchasers has on the quality of
   the product.
Quality in this case means, that as more agents join, more convenient and applicable service
becomes (in case of mobile telephony, as number of mobile phone users increases, the
incentive for new potential users to join also increases).
2) Indirect effect arising from hardware – software paradigm.
As number of mobile phone subscribers increases, network operators create and provide
more and more additional services (for example SMS, fax, email, MMS) which are also
incentive to join. In case of 2.5G and 3G these services can be provided not only by network
operators, but by external service providers, which will mean even more additional and
attractive services and applications.
3) Post purchase service development.




                                                                                            15
As current mobile communication networks in most countries do have full coverage of the
area, post purchase services are usually highly developed for most of the network operators.
Some post purchase services, such as handsets or prepaid SIM cards distribution, are provided
by other retailers which are not connected to network operators. This also has big impact as
positive network externality for mobile communication market.
Also Katz & Shapiro (1985) state that “For communication networks, the question is one of
whether consumer using one firm’s facilities can contact consumers who subscribe to the
services of other firms”. This is applicable to mobile communication networks, because
current networks are interconnected nationwide and worldwide with global roaming system.
But also we should not forget that international calls are still relatively costly service, when
compared to local calls. It’s rather obvious that in the future cost of international should
decrease significantly and this will also serve as even more powerful consumption externality.
Despite the fact that quoted paper already is two decades old and was written in significantly
different technological environment, it seem that it’s findings are universal and can are
applicable today.

Katz & Shapiro (1986) also provide us with the findings about technology adoption in
industries where network externalities are significant. Author of the master thesis intends to
link some of these findings with relevant examples about the current situation in the 3rd
generation mobile communication industry, where 5 incompatible standards (WCDMA,
CDMA2000, TD-SCDMA, UWC-136, and DECT) for possible technology adoptation are
present:

   1. Compatibility tends to be undersupplied by the the market, but excessive
       standartization can occur.

   This is very the case for a current situation of technology adoptation in 3G phones market.
   Despite the fact, that 5 major 3G standarts are present, major mobile phone producers
   (Nokia, Motorola, Sony Ericsson) are revealing handsets for only WCDMA standart, as
   most network operators which are starting to provide 3G services have chosen WCDMA
   platform for the current implementation of 3G. This does not mean, that other standarts
   will be forgotten (maybe they are under development or will be developed for the future
   3G), but up to date WCDMA has established itself as a leading 3G standart.




                                                                                             16
2. In the abscence of sponsors, the technology superior today has a strategic
       advantage and is likely to dominate the market.

   According to this finding, WCDMA is superior today even without major sponsoring
   activities and will dominate 3G market in the nearest future. This seems rather likely,
   because if the WCDMA technology will work as it is intended and will assure qualitative
   services according to 3G specifications, there will not be much incentive for network
   operators to invest in the creation of the networks based on other competing standarts.

   3. When one of two rival technologies is sponsored, that technology has a strategic
       advantage and may be adopted even if it‘s inferior.

   This might be applicable to WCDMA case – other competing standarts might be have
   technical implementation advantages, but as WCDMA was chosen by most important
   network components and handsets market players (for the reasons which remain
   unknown), it is cleat that this technology has a strategic advantage.

   4. When two competing technologies both are sponsored the technology that will be
       superior tomorrow has a strategic advantage.

   In the 3G market is also applicable, because major network equipment and handset
   producers might have chosen WCDMA as a leading standart, because they see that
   WCDMA technological capabilities assure it‘s ussage in the future.

Katz and Shapiro (1994) also examine network effect in the presence of systems competition.
First of all let’s look at how authors of the paper define concept of systems: “Many products
have little or now value in isolation, but generate value when combined with others. <…>
Products are strongly complementary, but they need not be consumed in fixed proportions.
We describe them as forming systems, which refers to collections of two or more components
together with an interface that allows the components to work together.” Authors also
separate two types of defined systems:
   •   Communication networks.
   •   Systems based on hardware software paradigm.
Communication systems allow various users exchange specific type of messages when they
join the system, which provides the “interface”. Interface is usually created and owned by
service provider and a tool, a component to access the network might be property of user or



                                                                                             17
provider. Obviously in case of telecommunication, that interface is network and components
are the phones. Concept of systems might define fixed telephony as well as mobile
communication industries.
Software - hardware paradigm systems both interface (hardware) and value providing
component (software) are usually purchased by the user (for example PC hardware and
software or CD player and audio CD’s). In some cased “hardware” might be sold under its
production costs and producers get its revenue from the sales of “software” (for example
Microsoft sells Xbox gaming console for ~50% of its production costs).
Typically both types of systems demonstrate observable presence of network effect. In case of
communication network systems “value of the membership to one user is positively affected
when another user joins and enlarges the network”. This is rather usual description which can
traditionally be found in most research papers of Katz and Shapiro. But network effect in
hardware software paradigm network is described differently: consumers form the expectation
about which systems are going to be popular and by buying software they encourage the
producers to achieve economies of scale, which is also specific type of network effect (value
obtained from the network increases as more users join).


Also authors point out three main features of systems competition:
   •   Expectations
   •   Coordination
   •   Compatibility
Rational expectations users form expectations about availability, price and quality of the
components they will be buying in the future. This effect is more obvious in case of software
hardware paradigm, because here users purchase “interfaces” themselves, but effect can be
observed in communication systems as well. In communication systems switching costs also
exist – usually access to the network is not granted for free, for example mobile phone users
must buy SIM card, fixed line phone users must pay phone line installation fee.
System markets also set challenges for the producing firms. Manufacturers taking part in both
type’s systems components and interface production must coordinate their action with other
components and interface producers as well. It is rarely the case when one producer can
successfully produce both interface and components of the system. Also the significant role
there is played not only by the market forces, but also by various industry-wide standard
setting bodies. The impact of standard setting bodies in case of mobile telephony was
addressed in first part of the master thesis.



                                                                                          18
Issue of compatibility between systems is also addressed by the authors, but in rather original
manner. Katz and Shapiro (1994) reject the idea that “incompatibility is just another
coordination failure”, and claim that “obtaining and maintaining compatibility often involves
a sacrifice in terms of product variety or restraints on innovation”. This idea could be used
when analyzing two different cases of introduction of new generation mobile communication
systems, because Katz and Shapiro (1994) pointed out that ”Incompatible systems also can
represent different generations of a single core technology”. So when second generation
mobile communication “interface” was introduced, it’s components (mobile phone) where
not compatible with first generation standard interface, but currently third generation mobile
phones are usually compatible with the existing second generation networks interface. Few
reasons explaining such situation might be pointed out:
   •   First of all, technically first generation and second generation where completely
       incompatible due to very different technology.
   •   Secondly, third generation services are seen as addition to main second generation
       services, usually still within the limited area (highly populated territories) and
       available only for those who have technically advanced expensive mobile phones.
       This could argument could be also supported support by Katz and Shapiro (1994)
       finding: “If the rival systems have distinct features sought by certain consumers, two
       or more systems may be able to survive by catering to consumers who care more about
       product attributes that network size.”
   •   Thirdly as network operators have made huge investment in to existing second
       generation networks, they upgrade current network component to fit third generation
       network, thus experiencing economies of scale, while it is rather costly for the new
       operator to enter the market and establish himself as new provider of third generation
       network.


So can be said that first and second generation could be called incompatible systems, while
second and third generation systems are compatible. But according to incompatible systems
definition by Katz and Shapiro “two communication networks are incompatible if subscribers
on one network cannot communicate with those on other networks”, we could say that any
generation mobile communication generation users can reach any other generation users by
voice calls; moreover they can communicate with totally different system – fixed telephony
network. Author of the master thesis would suggest update the concept of incompatibility in
following way “two communication networks are incompatible if subscribers on one network



                                                                                            19
cannot communicate in any existing network interface using               any existing network
component”, because as in this case systems might look incompatible, but actually their
interfaces are be linked.


   2.1.2     Stan Liebowitz and Steve Margolis
Two of these modern authors, who question „classical“ network effect paradigms and search
for more applicable models are Stan J. Liebowitz and Stephen E. Margolis.
In their network externalities and network effect definition, included as entry in „The New
Palgraves Dictionary of Economics and the Law“ authors primarily are trying to separate
widely used concepts of „network effect“, „network externalities“ and define them more
precisely:
„The enthusiasm for recognizing and understanding these phenomena should not, however,
lead us to inappropriate or premature conclusions. As we have noted above, there are
distinctions and reservations that ought to be maintained. The first and broadest is that
between network effects and network externalities. A further distinction is between pecuniary
externalities and real ones. Even for the set a real externalities, it is important to note the
distinction between the problem of network size and that of network choice, the boundedness
of the network effect, the likely symmetry of network effects for alternative products, the
ability of large consumers to self-internalize network effects, and differences in tastes.
Liebowitz and Margolis (1995) explain term “network effect” in following manner: “The
circumstance in which the net value of an action (consuming a good, subscribing to telephone
service) is affected by the number of agents taking equivalent actions will be called a network
effect” Author claim, that term “network externality” should be used to describe specific kind
of network effect, where “equilibrium exhibits unexploited gains from trade regarding
network participation”.

People when making a decision about joining a specific network (for example
telecommunication or computer operating system) always inevitably consider how their
participation will affect others and how the participation of others will affect us, meaning that
people consider what the people around them are choosing or are likely to choose.

Liebowitz and Margolis (1995) critically observe that so far the term “network externality” in
the research literature was always associated with positive effect, but that is only one part of
the picture. Negative effects caused by network externalities are also a part of our lifes, for
example when telecommunication or computer network reaches state of overload, any new



                                                                                              20
user joining the network will only decrease the utility of other user which they derive from the
consumption. Also there are network, where willingness of other people to join the network
harm each others interests – for example excessive demand for housing in particular area
causes price bubble thus making people pay more than they initially expected. This
understanding of network externalities expands areas of definition usage significantly when
compared to the definition of Katz and Shapiro.

Liebowitz and Margolis (1995) summarize that “goods exhibit network externality wherever
the consumer enjoys benefits or suffers costs from changes in the size of an associated
network, that is, changes in quantities demanded”. Authors notice that benefits and costs
resulting in such situation are directly connected to compatibility, brand familiarity, product
information, status, service availability or the prices of network related goods.

Also Liebowitz and Margolis (1995) add one more interesting dimension to the Katz and
Shapiro classification of networks of communication networks and networks based on
hardware – software paradigm (discussed earlier in the master thesis). Authors also classify
networks according to the ownership of network itself. They notice that in the communication
networks “participants are literally connected to each other in some fashion”, where network
creation requires investment of capital and property rights are always established for such
networks. In such networks users join only with the permission of network owner and use
network according to provided rules. Obviously mobile communication networks belong to
described category. Other type of networks, which correspond to Katz and Shapiro hardware
– software paradigm model, are named by             Liebowitz and Margolis as "metaphorical
networks" which are described as providing interrelationships in with no physical connections
used. These networks are not likely to have an owner, because usually it is not possible to
have one. Example could be drivers of particular car brand.


   2.1.3   Other authors
Despite the fact that Michael L. Katz and Carl Shapiro works on network effect and network
externalities are widely acclaimed as classical, after some time other authors are trying
critically review all the findings which others authors have made and explain areas of the
theory, which are not completely covered or lack real life evidence. Master thesis author
intends to include few example of such critical approach; one of them is Tim Weitzel, Oliver
Wendt, Falk v. Westarp recent paper “Reconsidering network effect theory”.




                                                                                             21
The authors claim that: “While the traditional models greatly contributed to the understanding
of a wide variety of particular (macroeconomic) problems associated with the diffusion of
standards, they fail to explain the phenomenological variety of diffusion courses in today’s
dynamic information and communication technology markets.“
Authors remark that current network externalities theory does not cover the heterogeneous
properties of the markets with new products such as digital television, cellular phones, office
software, Internet browsers, EDI-solutions. These are the markets and products, which where
not present during the time when “classical“network externalities where examined and need
further researches.
In the article, authors try "Systematically reveal deficiencies in the models of positive network
effects by analyzing common assumptions and conclusions, before extending this criticism to
the more general premises of the neo-classical framework.“




                                                                                              22
2.2 Diffusion of innovations
According to Encyclopædia Britannica2 diffusion of innovations definition:
“Some social changes result from the innovations that are adopted in a society. These can
include technological inventions, new scientific knowledge, new beliefs, or a new fashion in
the sphere of leisure. Diffusion is not automatic but selective; an innovation is adopted only
by people who are motivated to do so <…> Many innovations tend to follow a pattern of
diffusion from higher- to lower-status groups.”


Also mentioned higher status is defined as “young, urban, affluent, and highly educated, with
a high occupational status. Often they are motivated by the wish to distinguish themselves
from the crowd. After diffusion has taken place, however, the innovation is no longer a
symbol of distinction. This motivates the same group to look for something new again.”


2.2.1 Everett M. Rogers

Everett M Rogers in his book “Diffusion of Innovations” defines the diffusion of innovations
process saying that innovation is usually communicated “through certain channels over time
among the members of social system”. This means that four key elements are part of the
diffusion process:
      •   innovation – a product or other objects which is perceived by an individual as new;
      •   communication channels - intermediary by which messages sent from one individual
          or group reach another individual or group;
      •   time –      two time periods are present: innovation-decision process time and
          an individual or group innovation adoption process time;
      •   presence of social system social system.

Moreover Rogers (1963) segments of population which take place in the diffusion process
with their characteristics:

      •   Innovators - daring and the risk tolerant individuals with substantial financial
          resources to absorb possible loss from an unbeneficial innovation. They are intelligent,
          have ability to understand complex technical issues and do not feel uncomfortable
          with uncertainty of innovation;


2
    http://search.eb.com/eb/article?tocId=222921&query=diffusion%20of%20innovations&ct=



                                                                                                23
•   Early adopters – usually they are well integrated part of the social system having great
       degree of opinion leadership. They are viewed a role models, are respected and
       successful;
   •   Early majority group is described as interacting frequently with their peers, but rarely
       hold positions of opinion leadership. They are rather conscious before adopting a new
       initiative and constitute to about one-third of the members of a system, thus making
       the early majority the largest category taking place in the innovation diffusion process;
   •   Late majority also counts for about on third of the population. They adopt innovations
       by receiving pressure from peers or because of economic necessity. They share
       characteristics of being skeptical, and very suspicious.
   •   Laggards group hold no opinion leadership with point of reference in the past with
       limited financial resources.

Actually this segmentation is very applicable to the diffusion process of mobile
communication looking at the markets where mobile communication gradually established
itself going through all technical generations. Innovators where the first users, usually
financially unrestricted and interested in new technology, who purchased first extremely
expensive mobile communication sets and paid very high price for the services. At this stage
mobile communication was very niche market. After that, the wave of early adopters followed
when network coverage became larger. It was mostly institutional and business users. The
only distinction between the early majority and late majority in this case could only be the
difference of financial abilities, because after the technology has advanced, it was only a
question of time when it will became cheaper and will be accessible to most people in most
countries. This segmentation of course is relevant in the countries where mobile
communication was introduced gradually, because countries which adopted already
developed mobile communication technology (for example developing countries adopting
networks of 2G) are in little different situation, when users adopting the technology do not
take any adoption risk. The technology is already tried in other countries and they potential
adopters know technology usability. This means that in such countries only two major groups
could be observed: early majority and late majority, which only differ by financial limitations.
But in this case question arises whether it is really a diffusion of technological innovation.
When product is introduced in the new market not from the first stage of its lifecycle,
different analysis of adoption is required.




                                                                                             24
In addition Rogers (1963) points out five stages of the innovation adaptation process. The five
stages are:

   •   awareness is described as a stage, where individuals are directly exposed to the
       innovation although they lack complete information about it;
   •   Interest stage starts when an individual becomes interested in the new product or
       technology and sees additional information about it.
   •   Evaluation stage starts when individual psychologically applies the innovation to his
       predictable future situation and then makes a decision to try it or not.
   •   trial stage is considered a period when individual tries to get full use of the acquired
       innovation;
   •   Adoption stage is defined as a moment when the individual makes a positive decision
       about continues full use of the innovation.

2.2.2 Bass model
Mahajan and Muller (1979) claim that objective of a diffusion model is to present the level of
reach of an innovation among a potential adopters over time.
Moreover the rationale of the diffusion model is to show the successive increases in the
number of adopters and forecast the continued advance of a diffusion process already in
evolution.
In the product innovation perspective, diffusion models focus forecasting first-purchase sales
of innovations. They also might serve for the development of product life cycle. Mahajan et
al. describe diffusion models as “first-purchase models” assuming that in the product life
cycle timeline there are no repeat buyers (this means that number of buyer is equal to the
quantity of sold product).

The best known and most basic first-purchase model of new product diffusion was defined by
Frank M. Bass (1969).

Main idea of the Bass model lies in assumption that potential adopters of any innovation
receive influence influenced by two means of communication:

   •   mass media
   •   word of mouth




                                                                                            25
Basically model assumes two groups of potential new technology adopters take place in the
diffusion process. One group receives influence only by external influence channels – mass
media communication. Another group is a subject of internal influence – word of mouth
communication. Bass names the externally influenced group "Innovators" and the internally
group "Imitators". It is important to observe that the role of the groups in the diffusion of
innovation process differs by the timing of the involvement. Innovators are first to receive
information about new product and do have financial means t purchase it and ability to use
independently. This is rather similar to the definition of Rogers (1963). However imitators are
influence by personal connection with the innovators and in this manner the diffusion
happens. Bass model conceptual structure is graphically depicted Figure 3.1. Two curves
depict noncummulative dynamics of technology adoption by making difference between
Innovators and Imitators. Despite the assumption that innovators are usually the early
adopters, however decreasing percentage of the does exist throughout all the time period.
However it is not clear how some individuals can still be influenced only externally when the
curve of internally influenced users reaches its peak. Also one more questionable assumption
of Bass model is observed by Mahajan et al.

Technology adopter distribution assumes that an initial pm (a constant) level of adopters buy
the product at the beginning of the diffusion process. Once initiated, the adoption process is
symmetric with respect to time around the peak time T* up to 2T*. That is, the shape of the
adoption curve from time T*to 2T*is the mirror image of the shape of the adoption curve from
the beginning of the diffusion process up to time T*”. Usually it can be observed that after the
number of adopters reaches peak, market saturation level is not far away. This means that
after realistic curve should have much higher slope after the peak point in the graph.

Simplified Bass model calculating the total number n of technology adopters in time period t
is expressed by the following function:

n(t) = p + q

Where p is a number of innovators (which is calculated by knowing “coefficient of
innovations” – proportion of the potential innovators within population) and q number of
imitators (which is calculated knowing “coefficient of innovators”. Time dimension by having
different time periods for the innovators and imitators is added for more exact calculations.
However it is rather unclear how accurate coefficients of potential innovators and potential




                                                                                             26
imitators can be objectively obtained in the real product market. Bass model is extensively
quoted, interpreted and expanded in the innovations literature during last three decades. Few
interesting extensions of the model are provided below.

Tanny and Derzko (1988) imply that concepts of „Innovators" and "Imitators" used in Bass
model do not precisely describe characteristics of buyers taking part in the technology
adaptation process.
They offer an addition of the model in which all potential adopters are divided in two
distinctive groups which they label “Potential Innovators” and “Potential Imitators”. Potential
Innovators as well as Potential Imitators are a subject of the mass-media communication
influence, but only Potential Imitators are influenced by word of mouth, where Potential
Innovators are free of this influence. This seems really reasonable, because Potential Imitators
also receive also receive external mass media influence, but it might be, that this influence has
different consequence on their decision making process. Also as it was pointed out by Rogers
(1962) it might be that different groups might receive different quality of external media
provided information (for example people with more financial resources do have access better
quality information channels – satellite TV, international press).


One more interesting observation was made by Mahajan et al. (1990). A key characteristic of
the Bass model is that it addresses the market in the aggregate manner, measuring the number
of two groups adopters who acquire the product in time period t. Mahajan et al. (1990) raises
subsequent question: “Can the diffusion model be built by aggregating demand from
consumers who behave in a neoclassical microeconomic way? That is, assume that potential
adopters are smart and are not just carriers of information. They therefore maximize some
objective function such as expected utility or benefit from the product, taking into account the
uncertainty associated with their understanding of its attributes, its price, pressure from other
adopters to adopt it, and their own budget.”
This means that every single adopter both from imitators and innovators groups do have more
characteristics that it is taken in to account in the Bass model. That it is why one more
dimension should exist – it is probability of adopting the product in time t for consumer with
its specific characteristics. Mahajan et al. mentions several parameters which could be added
to the Bass model: individual uncertain perception of the innovation's performance, predicted
future value and benefits from the innovation. So only by looking at the micro level of




                                                                                              27
potential adopter, we can assume that individual will adopt the innovation when “his utility
for the innovation becomes greater than the status quo (he is better off with the innovation)”.




                                                                                              28
2. External – regulation factors influencing growth
In this section three articles three relevant articles are analyzed. John Kruse article discusses
the methods of conducting spectrum allocation. Harald Gruber article analyzes the role of the
regulation in the process of growth. This article provides us with the alternative example of
spectrum allocation in Hong Kong.




3.1 Methods of allocation of scarce resources
The study of Jorn Kruse (2002) examines various methods and options available for the
allocating scarce spectrum resources. Brief summary of the discussed methods is provided
below.
Kruse (2002) already in the introduction mentions that current developments of the mobile
telephony market can be characterized by low level of regulation in most countries, only with
significant exception of spectrum licensing.
Also he ads, that spectrum allocation methods by large shape industries and market structures
in the individual countries and as spectrum is a scarce resource, it is very important that
allocation lead to desired results of the efficiency of competition in the market.
Author remarks that “Spectrum is not only a technically essential resource. The availability of
more or less spectrum (and what kind of spectrum) is of primary importance for the economic
success of a mobile operator. Adequate spectrum allocation is a crucial factor, if a mobile
sector will be competitive and efficient or not.”


Kruse (2002) emphasizes the role of government (spectrum regulating body) in the process,
because its action has a strong impact on important characteristics of the market: the number
of the markets players, standards, competition rules etc.


Also author ads that spectrum can be described as an essential resource and the allocation of
spectrum is really significant for the level of competitiveness of operator and has an impact on
the competition and the efficiency of the whole industry.


Kruse (2002), before going into details of various spectrum allocation methods, explains
important the concepts of Intramodal and Intermodal Spectrum Allocation.




                                                                                              29
Term Intramodal Spectrum Allocation is used to describe the rivalry between similar services
operating within the same frequency thus creating the situation when spectrum becomes
subject to consumption rivalry.


Intermodal spectrum allocation describes the allocation of spectrum to different services (TV,
cellular mobile communication, or emergency). The allocation of the intramodal spectrum
dimension is traditionally decided by regulating body. However in the literature ideas
promoting the free market standardization process can be found.


Following methods for Frequency Resources Allocation are used by various countries
regulating bodies:
   1. First-come-first-served     was      most   commonly   used   during   early   days   of
       telecommunication, when monopoly situation existed. Companies (usually state
       controlled) where granted with the licenses without any competition. It was just a
       bureaucratic procedure without any intervention of the market forces. Nevertheless
       this allocation method was mostly used for the first generation mobile communication,
       but also in some countries first generation license holder was granted with the second
       generation license. However this method is not practiced in the market economies
       nowadays.
   2. Lotteries method also is rather rare case, but I was used in United States local digital
       markets, because the procedure is very simple and rarely a subject for legal
       complaints. However method does not warrant efficient use of spectrum, because
       second hand trade even prohibited by the regulators might take place using license
       holding company acquisition.
   3. Auctions are most commonly used method nowadays for spectrum allocation, because
       they have characteristics of being non-discriminatory and transparent. Also depending
       on the auction design they have relatively low transaction costs. As the market forces
       operate in this method, it is most likely that it will lead to the efficient use of
       spectrum. Also auctions are not very vulnerable for the potential corruption because
       influencing bodies do not leave much of discretionary control. Sometimes (as with the
       most European 3G licenses) they are seen as a source of significant contributions to
       the countries’ budgets. Auction designs can have few forms according to their
       institutional settings and rules:




                                                                                            30
•   The English Auction is most standard auction procedure also commonly used in all
       other market niches where auctions are conducted. It starts from a low price, when a
       bidder overbids the prevailing bid in each round. Auction ends when no higher price is
       offered and the remaining highest bidder is getting the license at his offered bid price.
       However the relatively simple procedure might become complicated when more than
       one license is offered simultaneously (frequencies in different regions).


   •   The Dutch auction is an opposite way when auction starts from a high price, which is
       automatically lowered if no bidders stop descending procedure.


   •   In the First-price sealed-bid-auction mechanism the bidders to submit a single (non-
       renewable) bid. The highest price bidder gets the spectrum license at his offered price
   •   In the Second-price sealed-bid-auction or Vickrey auction, the winner pays the price
       of the second highest bidder.


However most auction researchers agree that even simple auctions mechanisms are subject to
the risk of collusion, depending on the specific auction method. Even in the English auctions,
where it looks like incentives for cheating are almost non-existing, comparatively high risk of
collusion exists. By saying that Kruse (2002) remarks that most of European spectrum
auctions have been English auctions.


   4. Discretionary decision making is method which is fiercely criticized by free market
       economists’ because it usually is associated with corruption and fraud, as the
       regulating bodies have highest authority to choose the winner according to heir own
       standard. It might happen that these standards are set favorably for the companies
       which support ruling parties financially or even to family owned companies. Despite
       the fact this that most discriminating and intransparent it is still practiced in some
       African countries.
   5. “Beauty Contest” is procedure when potential candidates are evaluated on clear and
       transparent criteria by government regulating bodies or independent commissions.
       Sometimes this method includes auction elements or might serve for the creation of
       potential candidates list (Honk Kong spectrum licensing case will be discussed later in
       the thesis).




                                                                                             31
Kruse (2002) concludes the discussion about spectrum allocation mechanisms by stating that
“In general, economists strongly advocate auctions. But in practical terms, this very much
depends on the specific institutional framework and action design.”


Kruse (2002) also criticize European 3G license auction by saying that in spectrum auction,
unlike in other traditional market transaction where auction are employed, the objective
should not be the maximization of revenues, but “The proper functioning and efficient
outcome of the mobile markets are supposed to be the main objectives for the spectrum and
licensing auctions”. European 3G licensing will be discussed in more details within this
thesis.


Author also suggests questions which should be taken into account when developing a
spectrum allocation mechanism. They should include:
    •     Length of license duration and renewability.
    •     Spectrum tradability on a second hand market.
    •     Time schedule of auctions in relation to technological and market developments.
    •     Step-by-step-licensing or simultaneous licensing in the market.
    •     Advance notification of participation in the auction.



3.2 Role of regulation
Harald Gruber (2000) in his articles tries to answer the question what impact does the scarcity
of frequency spectrum makes on the performance of the mobile telecommunications industry.
Also in the paper author provides insights about the role of spectrum allocation together with
most important developments during the existence of spectrum allocation period. Brief
summary of the most relevant points of the article is provided below.


Author starts the article by emphasizing the importance of spectrum allocation in nowadays
mobile communication industry. The competition for the scarce frequency resources started
when first non monopoly operators where allowed to act as service providers. Despite the fact
that mobile telecommunications industry is constantly improving the spectrum efficiency used
for the services, the increasing popularity of mobile telecommunications services puts on
additional pressure for allocating even more frequency spectrum. Also as mobile




                                                                                            32
telecommunication is highly profitable business, with financially powerful operators,
spectrum licenses are becoming continue sly expensive.


Gruber (2000) reminds that from the of telecommunication industry, mobile communication
was seen as a natural monopoly, for the rational reason, that due to technically not advanced
systems, frequency spectrum availability was very scarce with poor efficiency of resource
usage. But regulators and other public bodies became more and more concerned that the
absence of competition in the industry leads to inadequate incentives to decrease costs and
also provides no suitable environment innovation with observable under-investment.
Frequency competition was born after the introduction of more advanced second generation
mobile communication systems, when some countries started issuing more than one license
for the providers of mobile communication services. After that the idea of fees for issuing the
licenses came into place. Thus mobile communications industry became the first major space
of competitive supply of telecommunications services.
Gruber (2000) claims that government licensing policy in mobile telecommunications has
following dimensions:
   1. Government needs to make decision about a single national standard or leave this
       decision for the market where multiple technological systems can compete.
   2. Government need to define the optimal number licenses to grant as well as timing on
       issuing
   3. Government needs to develop suitable licenses allocation method.


In the beginning GSM licenses were allocated mainly using “beauty contests” allocation
method in Europe. Also in some countries incumbent fixed line telecommunications operators
where granted with the licenses. However it was obvious that it can be only a temporary
solution, because as the market labialization was increasing (mainly due to impact of the
intereueopean regulation) competitive interaction among bidders was constantly increasing.
Gruber (2000) provides reflection of these trends using statistics about various countries
telecommunication sector: from 118 countries which adopted first generation mobile
communication systems 75% had monopoly, while from the 87 countries which adopted
second generation mobile communication systems 56% already had oligopoly.


Interpreting that Gruber (2000) makes an implication that “Capacity thus seems to be a first
crucial factor in explaining the effects of competition on the diffusion of mobile penetration.




                                                                                             33
When capacity is constrained, as under the analogue technology (especially during the early
years), the effects of competition on mobile penetration are likely to be modest. The effects of
competition are potentially much larger under the digital technology when capacity
constraints are relaxed.”


Gruber concludes the article by saying that the scarcity of frequency spectrum is still the
major concern of the mobile telecommunications industry. Despite the significant
technological progress that industry made during last decade, scarcity of the spectrum still has
limitation for the providers of the services.


   3.3 Alternative approach
This research paper of Xu Yan (2004) is reviewed in this master thesis as unique and
successful example of alternative approach of spectrum allocation. Hong Kong‘s spectrum
regulating body Office of Telecommunications Authority              after intensive debate and
consultation formulated 3G licensing scheme, which is very different from the traditional
spectrum licensing auctions used in Europe. Brief review of these differences and steps which
where taken upon reaching the unique solution is provided flowingly.


In the beginning of the research paper Xu Yan (2004) discusses difficulties, risks and
constraints which are inevitable when conducting spectrum auction in traditional manner.
These will not be reviewed there as it was discussed earlier in the thesis.


Also Xu Yan (2004) ads an interesting perspective of the problem by stating that the
difficulties of formulating a harmonizing licensing framework primarily are caused by
different economic backgrounds and existing spectrum allocation situation which determine
aspects of future spectrum allocation.


Analyzing the mentioned economic backgrounds and existing spectrum allocation situation
Xu Yan (2004) remarks that Hong Kong government (unlike some governments in EU) has
no need to raise significant revenue through spectrum auctions and can trade spectrum at
relatively liberal pricing scheme. This gives two benefits:


   1. Licenses can be obtained not only by the most financially powerful operators.
   2. Companies which get the licenses are not financial exhausted and can invest in to
       R&D for more innovative new services or have services provided at lower prices.



                                                                                             34
Xu Yan (2004) also insists that that 3G as a high-tech value adding industry with social
benefit much higher than the commercial benefit and will produce significant externalities if
any unfavorable situation developed. That‘s why government should take actions to reduce
the risk of potential investors. The most appropriate for the government for reducing the risk
is reducing operator’s financial risks by using convenient license pricing.
Knowing that Office of Telecommunications Authority eventually rejected primary proposal
of auctions and started the discussion about how the spectrum allocation process might be
constructed. At first it was only agreed that the practice that traditional procedure similar to
‘beauty contest’ will be used for formulating the potential license candidates list.
Also Xu Yan (2004) mentions that the allocation of radio spectrum was a non complicated
issue in Hong Kong, because most of the 3G defined spectrum has not been occupied by other
services and four 3G licenses can be issued.


However four 3G licenses is relatively small number taking into account that where issued 11
licenses in Hong Kong 2G market. The idea of the proposed solution how to deal with this
problem came originally from Europe – model very similar to Mobile Virtual Network
Operator concept (which exists in EURO) was offered. Mobile Virtual Network Operator is
based on the idea that some operators which do not have assigned radio spectrum can use the
proportion of spectrum of original Mobile Network Operators and be allowed to build and
operate parts of the networks which do not require the use of radio spectrum. When this
solution is used Mobile Virtual Network Operator are able to offer 3G services using their
own brands but not operating the radio networks, thus reinforcing the competitive market
model even more.


It was proposed that successful bidders which will be granted with the licenses will have the
obligation to open at least 30% of their 3G network capacity for usage of non-affiliated
Mobile Virtual Network Operator companies and/or content providers.


Concerning the pricing of licenses it was decided that price of the license should be negotiated
commercially. Only If commercial negotiation are not successful, the regulator has the right to
make own determination based on principles of fair interconnection, thus finding a balance
between to low price (‘‘free-rider’’ phenomenon) and a sufficient investment return on cost
of capital ( thus reflecting the higher risk of 3G service investment) . Mobile Virtual Network




                                                                                             35
Operator and content providers will buy negotiate the tariffs with Mobile Network Operator.
Negotiated tariffs might be a subject of regulators intervention and should reflect mentioned
return on the cost of capital.


Also the pre-qualification process was presented which was intended to be relatively liberal,
involve setting minimum criteria on investment, network rollout, service quality, financial
capability. Moreover very original license pricing scheme was introduced. Bidders where
asked to bid for a level of annual royalty (as a percentage of turnover) from 3G services
network operations. However for the first 5 years of operations, minimum royalty payment
will fixed by the government, because it will be complicated to distinguish between second-
generation mobile service (2G) and 3G network revenues, as most of 3G licensees will be an
existing 2G operators.


Starting from year six to the end of the license period, 3G Mobile Network Operator will pay
royalties to the Government according to the royalty percentage which is determined by the
auction. The calculate actual royalty payment of course will different for different Mobile
Network Operator as they will have different 3G revenue turnover.


Concluding the research paper Xu Yan (2004) states that „It is important to point out that the
open network obligation of 3G licensees has been fully debated before the licenses were
auctioned, and all bidders have been very well informed about the potential competitiveness
of the 3G market. As a result, no bidders should be so nave as to unreasonably overbid the
licenses, especially in the context that several European licensees are suffering from the
winner’s curse. “


In this way government also is not losing either, because the continues royalty payments will
allow the government strengthen possibly unstable future 3G services market with almost no
financial risk. Hong Kong’s 3G licensing scheme might be seen a balance between scarce
spectrum efficiency and working market competition thus providing an alternative way of
thinking about the problem.




                                                                                           36
4. Empirical analysis
4.1 Example of empirical research
4.1.1 Massini’s research
Massini’s (2004) study investigates the diffusion of mobile telephony in Italy and UK using
the 1990s. Massini used the following data variables for its research:
   •   Subscribers Monthly series
   •   Tariff Average annual revenue per subscriber
   •   Price of the Handset
   •   Final Consumption Expenditures,
   •   Consumption Price index to deflate the series of the price of the
   •   Active population
Author defines an aggregated diffusion model, based on the standard epidemic model, by
introducing economic variables.
In addition to the economic variables authors also ads variable that takes into account the
effect of the technological change which occurred in mobile telephony during the researched
period. This change was the shift from analogue (1G) technology to digital (2G) technology.
This variable also might be interpreted as a factor for quality changes.


In the paper author defines and estimates diffusion curves of mobile telephony users in Italy
and the UK during the 1990s, using standard epidemic model and taking into account of
economic and technological factors that are helpful in explaining differences of the diffusion
speed. Also they suggest methods to differentiate long-run relationships and short-run
adjustments of continuous diffusion.
Interesting remark is that, two countries have very similar characteristics (size, wealth,
population and geographical features), exactly the same mobile telephony services
introduction year (1985). Even so investigation market structures and institutional regulation
frameworks, shows remarkable differences in two countries: Italy had          near monopoly
situation until the introduction of the second operator in 1995, while in the UK the service
where started from duopoly model which was enriched by the entry of a two more operators
in 1994.
Also author notices, that the strategies local mobile network operators employ, shows
observable differences in Italy and United Kingdom. Italian operators where primarily
competing by introducing innovative pricing packages, including the introduction first




                                                                                           37
prepaid SIM card in 1996. British operators chose to use subsidies for the cost of the handset
thus locking customers to their networks.
This resulted in differing portfolios of clients in both countries with different tariff packages
in both countries:
   •   Large number of prepaid cards and pay as you go contracts, which do not require high
       connection fees.
   •    Large number of subscribers to knowing their own needs and operator’s
       characteristics with discouragement to switch network.
Massini (2004) remarks that “Although the prepaid customers tend to spend less than contract
customers and reduce the average revenue per subscribers, the success of prepaid services in
Italy and UK has been such that the total profits for the operators are growing continuously.”
Also author insists that improved marketing of services and information presentation was
employed by the operators because of constantly increasing variety of products and services
which ads substantial complexity and confusion when buying a mobile phone.


Before conducting the empirical investigation, author extensively explains the diffusion
process of S-shaped profile by describing to counteracting forces involved in the process.
First force is the increasing number of the adopters which acts positively on the diffusion; the
second force is decreasing number of potential adopters.
Author also notices that “the epidemic feature is not simply spread of information about the
existence of the innovation, but also spread of information concerning its technological
characteristics and the increase in post-adoption profitability”. This can be seen as a wise
strategy for the developers and promoters of any innovation: it is necessary to reduce the
potential adopters decision making process by reducing degree of uncertainty associated with
the innovation. As more information about the innovation is available from various sources,
critical mass of the adopters is reached.


Massini (2004) finds out those profiles of the number subscribers of mobile telephones shows
typical S-shaped curve both for Italy and the UK. Also author observes that number
subscribers of analogue first generation technology reached its maximum saturation level both
in Italy and the UK in 1996, after which the decline follows.
As it is typical for competing product generations the two technologies had showed same
market shares in 1997, but in both countries analogue telephones started to disappear while
digital telephones have grown even faster after that.



                                                                                              38
Also author remarks that from the point of view of the operators, the cost of the infrastructure
for the digital technology due to some specific technical reasons was lower and required much
smaller investment when compared to the analogical technology. This means that service
providing even better quality can be cheaper that lower quality old generation service,
meaning that there is no real competition between technologies and switching of consumers is
only a question of time
Author adds that:”The profiles of the subscribers of the analogue and digital technologies
follow the characteristic pattern of technological substitution between successive generations
of technologies, where a new generation cannibalize the previous one and will be
cannibalized by the next generation”


Author summarizes the following results of the most important in the researcher:


   1. The assumption that the introduction of the digital technology (2G) had a significant
       improvement for the Italian subscribers, but not significant for UK subscribers is
       strongly supported by empirical results. Author gives a following explanation to this
       finding: “If the trend represents learning factors it could be argued that the British
       market was already quite mature when the digital technology was introduced and the
       learning processes on the new technology have been increasingly less important. “


   2. Result show is that economic variables have an important in both the diffusion speed
       and the saturation level. Most important variables where tariffs and price of handset.
       Price of the handset was less significant in UK that in Italy and this is explained by the
       fact that handsets are traditionally largely subsidized in UK. Tariffs where highly
       important in both countries
   3. Author applies the Error Correction Model and gets the result which demonstrates
       “that the variables affecting the diffusion speed tend to be significant in the long run,
       but they do not affect the process in the short run, and they do not explain the
       deviations from the long run pattern.”


Author suggests for future researchers to add more factors:
   •   market structure;
   •    infrastructure indivisibility;
   •   some characteristics of the handset,



                                                                                              39
•   the coverage rate;
   •   information on the fixed lines, like its relative costs compared to the mobile network;
   •   longer and updated data on the three generations of mobile communication
       technology.
4.2.1 Botelho research
The recent paper of Botelho, Pinto (2004) paper analyses the pattern and rate of adoption of
mobile telephones in Portugal. Time-series data on the number of subscribers is analyzed
using statistically based method to estimate the market potential for mobile phones is
employed, allowing generation of confidence intervals about the estimated market potential.
The nature of the used method allows researchers not only to empirically derive the expected
market potential, but also to determine the current stage of the market with respect to
saturation level and make observations about growth process.


Botelho et al. (2004) estimated the S-shaped diffusion functions (exponential, Gompertz, and
logistic) growth models using time series data on the number of cellular phone subscribers) by
ordinary least squares method for exponential function and nonlinear least squares for
Gompertz function. The find out that:
   1. Exponential growth model has high coefficient of determination and high t-statistics,
       but model clearly overestimates number of cellular phone subscriber’s growth rate.
       Author concludes that exponential growth curve does not provide a very realistic
       description of the cellular phone diffusion in Portugal.
   2. Results using the Gompertz model show that the saturation of Portugal mobile phone
       users market is 25% than Portugal’s population rate and author declares this as
       unreasonable suggesting that Gompertz model does not provide accurate forecasts of
       the growth phenomenon.


However article was originally written in 2001 and the last data used is from 2000. Recent
mobile phone user’s statistics show that in some countries the saturation level has already
overcome 100%. This is possible because increasing proportion of population is using few
SIM cards for various purposes.


   3. High t-statistics for each of the estimated parameters in the logistic model results
       indicates an excellent fit with the data. Also logistics model demonstrates a realistic
       saturation level of 67% of population.



                                                                                             40
Author concludes the paper saying that conducted research demonstrates that the adoption of
cellular phones in Portugal can be explained by S shaped -curve.


Also he ads that “although both the Gompertz and logistic models describe a sigmoid
diffusion curve, it is only the logistic model that adequately describes the path of cellular
phone diffusion in Portugal.”


The reason for this is rather technical: the Gompertz model is derived from a skewed
frequency distribution, while the logistic model is based upon a symmetric frequency
distribution which fits researched situation much better. Also logistics model depicts the rate
of diffusion in Portuguese cellular phone market better because it is closer to symmetric,
while reaching its maximum growth at an earlier phase as Gompertz function suggests.


Functions
Botelho et al. (2004) provides us with the specification of the traditionally used functions
which depict S-shaped diffusion process. As author of the master thesis also performs
statistical data analysis similar to the one conducted by Botelho et al., overview of these
functions with brief descriptions is provided flowingly.


Botelho et al. (2004) explains the usage of S-shaped diffusion model in following manner:
“Irrespective of the particular account of the diffusion process, the stylized diffusion path of
most innovations results from the fact that initially, during an embryonic phase, only a few
members of the social system adopt the innovation. Over time, though, an increasing flow of
new adopters is observed as the diffusion process unfolds. This is the phase of rapid market
growth. Finally, during a maturing phase, the trajectory of the diffusion curve gradually slows
down, and eventually reaches an upper asymptote or saturation level.”




Traditional evolutionary pattern S-curve is expressed a differential equation:




                                                                                             41
Where:
   •     y(t) is the cumulative number of subscribers at time point t;
   •     y* is the saturation level
   •     γ is the coefficient of diffusion.


Main assumption of the model is that number of subscribers growth rate is positively
influenced by the number of existing subscribers and the difference between the saturation
level and the number of existing subscribers.


Mostly used functions of S-curves representing are the logistic, the Gompertz and exponential
functions. Each of them is described below.


The Gompertz function is expressed as
_________________________________________________________________________




Where:
   •     yt is the number of existing subscribers at time t;
   •     k; a; and b are parameters to be estimated.


The Gompertz function values ranges from a lower asymptote of zero to the upper bound k,
while t ranges from negative infinity to positive infinity. The parameters a and b are used for
determining the location and the shape of the curve.


The logistic function is expressed as:




Where:
    •    k determines the upper bound of yt;
    •    parameters a and b determine the location and shape of the curve.


The logistic curve reaches its maximum growth rate kβ=4 when yt ¼ k=2. The logistic curve
is symmetric about its inflection point.



                                                                                            42
The exponential function is expressed as: :______________________________________



Where:
   •     ln yt is the natural logarithm of the number of existing subscribers at time t;
   •     coefficient b determines the constant proportional change in the variable y.



4.2 Empirical data analysis
In this section empirical data analysis using various statistical techniques is conducted.
First of all correlation between number of Lithuanian mobile phone subscribers and economic
variable will be analyzed (GDP, average income). This should give an answer to the question
weather decision to become a mobile phone user is influenced by economical factors. Also
correlation number of Lithuanian mobile phone subscribers and the number of fixed line
subscribers will be employed, to answer the question weather the decision to become a mobile
phone user is influenced by technological substitution factor.


Secondly regression is employed also to test the relationship between number of Lithuanian
mobile phone subscribers and mentioned independent variables (GDP, average income,
number of fixed line subscribers). Additionally to the simple regression, multiple regression
models are used to test to test the relationship between variously paired independent variables.


Thirdly number of Lithuanian mobile phone subscribers is analyzed using time series method.
Different functions for time series are employed and analysis is should provide an answer to
the question which of which of the used function can describe the variation precisely. Also
exponential function is analyzed as in the Botelho, Pinto (2004) research and results are
compared.


Data on the number of Lithuanian mobile phone subscribers for the research is available for
the period 1996 – 2004, as 1996 was the first year when data about generation mobile
communication was started to be collected in Lithuania.




                                                                                             43
Table 4.1 Cumulative data of mobile phone and fixed line subscribers.
             Mobile            Fixed    line
Time
             subscribers,      subscribers,
period
             thou.             thou.
1996         51                992,6
1997         150,8             1048,2
1998         267,6             1109,8
1999         343,6             1144,6
2000         508,9             1180,1
2001         1018              1144,5
2002         1631,6            929,6
2003         2152,6            827,8
2004         3421,54           776


Source: Lithuanian Statistical Department, (http://www.std.lt)


GDP data and average income is adjusted is adjusted according to 2000 price level.


Table 4.2. Economical variables
                            Average
Time         GDP,      in
                            income,
period       thou LTL
                            LTL
1996         38821          618,2
1997         41541          778,1
1998         44565          929,8
1999         43810          987,4
2000         45526          970,8
2001         48429          982,3
2002         51704          1013,9
2003         56716          1072,6
2004         60511          1157,8


Source: Lithuanian Statistical Department, (http://www.std.lt)




                                                                                     44
4.2.1   Correlation analysis
In Table 4.3 the results of strength of relationship between number of mobile phone
subscribers and yearly GDP is demonstrated. We can see that Pearson correlation coefficient
implies that positive correlation with very strong relationship exist between variable.
Coefficient value 0,974 is very near to perfect correlations, meaning that the variables are
precisely related. Also we can observe that this correlation is statistically significant, with
probability value lower than 0,001.


Table 4.3 Correlation. Number of mobile phone subscribers and GDP.
Correlations
                                                               Mobile_subscri
                                                                                GDP
                                                               bers_thous
Mobile_subscribers_thous          Pearson Correlation          1                0,974
                                  Sig. (2-tailed)                               0,000
                                  N                            9                9
GDP                               Pearson Correlation          0,974            1
                                  Sig. (2-tailed)              0,000
                                  N                            9                9
**. Correlation is significant at the 0.01 level (2-tailed).


Scatter diagram of variable (Figure 4.1) also demonstrates that when one variable increases,
another variable behaves in very predictable way:




                                                                                            45
Figure 4.1. Scatter diagram for mobile phone subscribers and GDP




In Table 4.4 we can see the results of relationship between number of mobile phone
subscribers and average income. Pearson correlation coefficient value 0,773 demonstrates
rather strong positive relations between variable. However we can clearly observe that
relationship between the variables is statistically insignificant with probability value 0,015.


Table 4.4 Correlation. Number of mobile phone subscribers and average income.
 Correlations
                                                               Mobile_subscri   Average_Incom
                                                               bers_thous       e
 Mobile_subscribers_thous          Pearson Correlation         1                0,773
                                   Sig. (2-tailed)                              0,015
                                   N                           9                9
 Average_Income                    Pearson Correlation         0,773            1
                                   Sig. (2-tailed)             0,015
                                   N                           9                9
 *. Correlation is significant at the 0.05 level (2-tailed).




                                                                                                  46
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
Master thesis from BI
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Master thesis from BI

  • 1. INTERNATIONAL SCHOOL OF MANAGEMENT MASTER OF SCIENCE PROGRAMME Nerijus Dumbrava Student ID: 0786324 MASTER'S THESIS TITLE OF THE THESIS Supervisor Nerijus Pačėsa 2005 _ _ Supervisor Lars Thue 2005 _ _ Reviewer 2005 _ _ Reviewer 2005 _ _ VILNIUS, 2005
  • 2. CONTENTS List of Figures 2 List of Tables 3 Introduction 4 1. Overview of 1G, 2G, 2.5G, 3G mobile communication systems 7 1.1. First generation (1G) 7 1.2. Second generation (2G) 9 1.3. Intermediary generation (2.5G) 11 1.4 Third generation (3G) 11 1.5 1G, 2G, 2.5G, 3G compared 13 1.6 1G, 2G, 3G in Lithuania 14 2. Internal - structural factors influencing growth 15 2.1 Network effect 15 2.1.1 Michael L. Katz and Carl Shapiro 15 2.1.2 Stan Liebowitz and Steve Margolis 20 2.1.3 Other authors 21 2.2 Diffusion of innovations 23 2.2.1 Everett M. Rogers 23 2.2.2 Bass model 25 3. External – regulation factors influencing growth 29 3.1 Methods of allocation of scarce resources 29 3.2 Role of regulation 32 3.3 Alternative approach 34 4. Empirical analysis 37 4.1 Example of empirical research 37 4.1.1 Massini’s research 37 4.1.2 Botelho research 40 4.2 Empirical data analysis 43 4.2.1 Correlation analysis 45 4.2.2 Regression analysis 48 4.2.3 Curve estimation 53 Conclusion 58 References 60 1
  • 3. LIST OF FIGURES Figure 4.1 Scatter diagram for mobile phone subscribers and GDP Figure 4.2 Scatter diagram for mobile phone subscribers and average income. Figure 4.3 Scatter diagram for mobile phone subscribers and fixed line subscribers Figure 4.4 Curve fit analysis for Linear, Quadratic, Cubic and Power functions Figure 4.5 Curve fit analysis for Compound, S, Growth, Exponential and Logistics functions 2
  • 4. LIST OF TABLES Table 1.1 Table 1.1 features of 1.5 1G, 2G, 2.5G, 3G mobile communication generation systems Table 4.1 Cumulative data of mobile phone and fixed line subscribers. Table 4.2. Economical variables Table 4.3 Correlation. Number of mobile phone subscribers and GDP. Table 4.4 Correlation. Number of mobile phone subscribers and average income Table 4.5 Correlation. Number of mobile phone subscribers and fixed subscribers Table 4.6 Regression coefficients. Mobile phone subscribers and fixed line subscribers Table 4.7 Regression characteristics. Mobile phone subscribers and fixed line subscribers Table 4.8 Regression coefficients. Mobile phone subscribers and GDP Table 4.9 Regression characteristics. Mobile phone subscribers and GDP. Table 4.10 Regression coefficients. Mobile phone subscribers and average income Table 4.11 Regression characteristics. Mobile phone subscribers and average income. Table 4.12 Multiple regression coefficients. Mobile phone subscribers, fixed line subscribers and GDP. Table 4.13 Multiple regression characteristics. Mobile phone subscribers, fixed line subscribers and GDP. Table 4.14 .Multiple regression coefficients. Mobile phone subscribers, fixed line subscribers and average income. Table 4.15 Multiple regression characteristics. Mobile phone subscribers, fixed line subscribers and average income. Table 4.16 Time series functions results. Table 4.17 Estimation results of the exponential model 3
  • 5. INTRODUCTION Mobile communication is one of the most exciting technological developments of last decade. No segment of any other industry has seen growth that happened in mobile communications. From relatively modest start, the last 15 years where an explosion in the number of mobile communications users. Starting from early introduction in 1990, number mobile telephone subscription has doubled globally every 20 months. Starting from an 11 million subscriber and an average penetration of 1% at 1990, the mobile communications industry now provides services to 1,404 billion subscribers (International Telecommunication Union, 2003). As the number of mobile subscribers in some countries is already overtaking fixed line subscribers and reaching saturation level higher than 100%, it looks that mobile communication is becoming primary mean of voice communication transmission However it appears, that growth is likely to continue in the future taking even more interesting forms after the introduction of technically advanced mobile cellular networks. This master thesis is intended to examine the growth of mobile telephony and the factors that affect this growth. Varying explanations of the growth factors can be found in the vast research literature of the subject. Gary Madden, Grant Coble-Neal, Brian Dalzell (2004) suggest that one of the reasons of such impressive growth over last decade could be market situation itself, because the situation in mobile telecommunication sector from the early start was very different than in the sector of traditional fixed line telecommunication. Authors remark that “Entry of mobile providers into former monopoly markets ensured the evolution of a more competitive environment.” From the very first mobile operators where operating in very competitive environment, because usually in most countries at least two service providers where issued with the licenses. That’s is why operators had to employ the strategies based on high customers satisfaction: developing pricing packages to differentiate themselves from their competitors, isolate market segments and target specific customer groups and geographic regions Jha and Majumdar (1999) have find out that mobile telephony penetration is varying considerably amongst different countries depending to their gross domestic product (GDP). Authors insist that bigger economical success translates into an superior demand for mobile telecommunications services. 4
  • 6. Gruber, Verboven (2001) notice that growth in mobile telephony might be affected by such regulatory influences as the timing and number of licenses issued the method which is used to grant the licenses, timing and manner of technological standardization. However Erik Bohlin, Stanford L. Levin, Nakil Sung in the editorial of Special Issue on Growth in Mobile Communications of Telecommunications Policy remark that “As is widely recognized, accurately predicting the evolution of demand for new applications of technology has eluded experts again and again. The history of mobile communications has been characterized by underestimation of overall demand, overestimation of the potential of certain applications (such as WAP), and the failure to foresee the popularity of others (such as SMS).” But the authors also add that complicatedness of forecasting does not necessarily mean that various interest parties in the mobile communications field cannot impact developments by creating environment for expansion, meaning that it main concern should be put on identifying and removing concrete barriers to continues growth. Balance should be found between the requirements of consumers and demands businesses, the availability of infrastructure and development of services, the financial equilibrium of operators, equipment developers and other players in the mobile wireless area and the control employed by various regulatory bodies. Development of technologies ads one more interesting feature to the picture – services of data transmission over mobile devices under 2.5G and 3G systems are already offered in some markets. Already today there are many prediction and different opinions how these systems should work, how their services should be priced and how consumers will react. Author of master thesis also intends to touch this topic from theoretical where it is applicable, addressing the challenges that will appear then the technological generation will change. The thesis is organized as follow: Section 1 is addressing technical issues related to the evolution of mobile communication networks. It is intended to provide information about standards, generations, and timeline of the evolution until current date and brief overview of mobile communication networks development in Lithuania. 5
  • 7. Section 2 provides discusses of relevant theoretical concepts from theory of economics of innovations literature. To aid this discussion two most relevant subjects where chosen and will be addressed: 1. Network effect 2. Diffusion of technological innovation Mentioned concepts are studied having in mind their impact on researched topic thus linking some of the researcher’s theoretical findings with practical examples from mobile communication industry. Also these findings and concepts will be used in empirical part of the research. Section 3 will be used to address the role of state regulation by reviewing relevant researches mainly about auctions of frequency distribution. Section 4 concludes the paper by performing empirical research of growth factors of Lithuanian mobile communication market. Existing researches on similar topic will be reviewed in this section as well. General focus research question: How has mobile communication industry developed to current stage? Which factors and how influenced growth of mobile subscribers? Author assumes that following research questions with corresponding objectives should be addressed in his research: Research question Research objective 1. How has mobile communication 1. To overview creation, main developed till now? principles and development of GSM standard 2. What implications, concepts and 2. Examine the theoretical ideas does literature provide about concepts of network effect and the possible reasons for growth diffusion of technological mobile communication? innovation and find possible links with the growth. 3. What is the current role of market 3. Overview the researches regulating bodies in fostering or examining role of regulation and decreasing the growth? methods of regulation. 6
  • 8. 4. Compare quantitative analysis 4. How main factors driving mobile results. communication growth can be captured? 7
  • 9. 1. Overview of 1G, 2G, 2.5G, 3G mobile communication systems Before deeply analyzing driving forces of mobile communication development and its current state, it is appropriate to review mobile communication technical development timeline, not forgetting first and second generation systems. Like in most information technologies, advances in mobile communications occur through a process of gradual evolutionary development and the “occasional quantum-leap forward” (Clint Smith, 2001) periods. This development is also characterized by term “hype cycle” by Gartner researchers1. That’s why it is important to review development of mobile communication systems and try to observe patterns of the possible past hype cycles, which might be a useful tool for the predictions and forecasts about upcoming generation of mobile communication systems. Also before analyzing such a complex and dynamic industry as mobile communication, it is important to have some knowledge about basic technical details to better understand what is the environment of the industry in which decisions are made. 1.1. First generation (1G) Most of researchers, analyzing development of mobile communications systems, mention USA as a place, where mobile communication technologies where born. First successful implementation of the trial system was conducted in Chicago in 1978. The system was based on technology called Advanced Mobile Phone Service (AMPS) and was operating at 800MHz frequency. Commercial launch of this system was delayed and took place only in 1983. However other countries were also making significant progress. Japan has launched a commercial mobile communication system in 1979. System was based on the same Advanced Mobile Phone Service platform which was tried in the USA in 1979. In 1981 the first European mobile communication system was launched in Norway, Sweden, Denmark, and Finland simultaneously. This system used a technology known as Nordic Mobile Telephony (NMT) and was operating in the 450MHz band and became known as NMT-450. Later version of the system was working in 900MHz band and was named NMT-900. System was widely recognized as a successful project and later was installed throughout Europe, Asia, and Australia. 1 http://www4.gartner.com/pages/story.php.id.8795.s.8.jsp 8
  • 10. Britain introduced at that time has chosen to adopt its own technology which was called Total Access Communications System (TACS) and took place in 1985. Actually TACS was upgraded version of AMPS, which was installed in USA and Japan. In a few years time many other developed countries followed along joining the growing community of mobile communications users, and soon mobile communications services spread across the continents. During that time several other technologies were developed, but AMPS, TACS NMT450 and NMT900 were the most successful and most widely adapted technologies. Some of these systems are still in service even today. As (Collins, 2002) writes “First-generation systems experienced success far greater than anyone had expected.” But every success has its own limits. As the number of subscribers grew rapidly, they exceeded potential capabilities of the systems, especially in the highly populated areas. Due to specific architecture of the systems, it was already impossible to assure good quality of the service and it was clear that actions should be taken immediately. This lead to the development of second generation systems (2G). 1.2. Second generation (2G) Year 1982 could be called a virtual starting point for the development of second generation system, because in this year the Conference on European Posts and Telecommunications (CEPT) embarked on developing new generation mobile communication system by establishing a group called Group Spéciale Mobile (GSM, which later become an acronym for second generation standard). After conducting an early technical work of the new digital standard, work was overtaken by the newly created European Telecommunications Standards Institute (ETSI) in 1989. ETSI finalized the first set of technical specifications giving the same name of an earlier standard developer’s group– GSM. The first functioning GSM network was set up in 1991, followed by several more launched in 1992. Also international roaming between the various networks soon followed. GSM was regarded as hugely successful project and within few years almost all countries in Europe between 1992 and 1996 set up GSM service, followed by countries in other continents. It became evident that GSM will be more than just a European project - it was fast becoming global, by changing the meaning of GSM letters to “Global System for Mobile communications” 9
  • 11. Consequently, the letters GSM have taken on a new meaning—Global System for Mobile communications. After few years one more important enhancement followed. Originally, GSM was designed to operate to use 900MHz band, but to increase network capacity 1800MHz band was added to the standard, called DCS1800 since which function simultaneously with the old frequency. New sets of handsets where developed to support both frequencies. Nowadays most handsets support also 1900 MHz frequency which is used for GSM in North America. (Collins, 2002) mentions following benefits of 2G systems over 1G: 1. Increased capacity over analog technology 2. Reduced capital infrastructure costs 3. Reduced the capital per subscriber cost 4. Reduced cellular fraud 5. Improved features 6. Encryption Most of the mentioned points directly benefit operator of the wireless system, but benefits which users receive can also be observed: 1. Lower service cost (due to reduced capital infrastructure costs and increased capacity of the network) 2. Better voice quality, higher success of connection 3. Additional features, new services (SMS, international roaming, sim card options, data transmission) Many reasons for the rapid growth of second generation mobile communication (most of these reasons will be addressed later in this thesis), but one important detail should be mentioned above all of them. GSM was highly technically advanced technology (and still is), because system design was made from the scratch without providing backward compatibility with existing analogue systems. This results in following: 1. System offers much mores advanced technological features, and is not connected to previous generation analogue technology by any means. 2. Network operators are encouraged to build new networks as fast as possible because there is no backward compatibility. 1.3. Intermediary generation (2.5G) 2.5G could be called an intermediate mobile communication generation linking existing 2G with 3G which is still under development. 2.5G basically is the method by which existing cellular operators are migrating into the next generation wireless technology, which is 10
  • 12. extensively specified the International Mobile Telecommunications-2000 (IMT-2000) specification. For the implementation of 2.5G, there is no need to build totally new network, because services are provided by upgrading current 2G equipment. This means that 2.5G offers a backward compatibility which is extremely important having in mind huge investment which will be required to set up 3G networks. Following platforms are currently used in 2.5G systems: • General Packet Radio Service (GPRS)/ High Speed Circuit Switched Data (HSCSD) • Enhanced Data Rates for Global Evolution (EDGE) 2.5G gives the wireless operators a possibility to provide digital high speed data transmission services prior to the availability of 3G platforms. Providing 2.5 services, before 3G is very beneficial to the operator: 1. They can research customers needs 2. They can develop various pricing schemes 3. They have time to “educate” the customer about services which high data transmission technology provides On the other side, (Collins, 2002) mentions following challenges for the operators engaging in providing 2.5G services: 1. No one specific standard chosen for transition. 2. The overlay approach 3. The introduction of packet data services 4. The new user devices required 5. New modifications to existing infrastructure 1.4 Third generation (3G) The demand for the next generation mobile communications technology became observable during the period of rapid development and usage of networking technologies in the 90’s, especially internet. Users soon realized that presence of a constant high speed connection enables them to perform variety of different activities which prior where hardly possible or even imaginative. Adding feature of mobility to the high speed access point would widen the possibilities of high speed data transmission services even more. 11
  • 13. Recognizing that fact, The International Telecommunications Union (ITU) in the 1990’s launch the initiative called Future Public Land Mobile Telecommunications Systems (FPLMTS) which was meant to prepare recommendation for the next generation mobile communication systems. In 1997 ITU presented the recommendations under the name “International Mobile Telecommunications—2000” (IMT-2000) which gave general direction for the development of 3G mobile communication systems. The IMT-2000 recommendations were intended to be unifying specification, enabling mobile high-speed data services using one or several radio channels based fixed network for providing the services under following conditions: 1. Global standard 2. Compatibility of services within IMT-2000 and other fixed networks 3. High quality 4. Worldwide common frequency band 5. Small terminals for worldwide use 6. Worldwide roaming capability 7. Multimedia application services and terminals 8. Flexibility for evolution to the next generation of wireless systems 9. 2Ghz operating band 10. High-speed packet data rates: a. 2 Mbps for fixed environment b. 384 Mbps for pedestrian c. 144 Kbps for vehicular traffic As these where only general recommendation, ITU announced that it is open for the submission of technical 3G implementation proposals. After these proposal where submitted, 5 technologies for terrestrial service where announced: • Wideband CDMA (WCDMA) • CDMA 2000 (an evolution of IS-95 CDMA) • TD-SCDMA (time division-synchronous CDMA) • UWC-136 (an evolution of IS-136) • DECT 12
  • 14. 1.5 1G, 2G, 2.5G, 3G compared Following table summarizes all mobile communication generation systems features, standards, specifications. Table 1.1 features of 1.5 1G, 2G, 2.5G, 3G mobile communication generation systems Generation Standards Features Speed Band Analogue voice service, 300MHz - 1G AMPS No data service 600MHz Digital voice service; Low speed data transmission; CDMA,TDMA, Enhanced calling 9.6K - 14.4K 600MHz - 2G GSM,PDC features, caller ID; bit/sec 1.8GHz Voice mail; Short messages; Global roaming Phone calls/fax; Send/receive medium size email messages; GPRS, EDGE, 2.5G Web browsing; 64-144kb/sec HSCSD, Navigation/maps; New updates; Multimedia messages 1.5GHz - Send/receive large email 3GHz WCDMA, messages; CDMA2000, High-speed Web; 144kb/sec- 3G TD-SCDMA, Navigation/maps; 2mb/sec UWC-136, Videoconferencing; DECT TV streaming; Electronic agenda 13
  • 15. 1.6 1G, 2G, 3G in Lithuania First 1G generation mobile communication NMT-450 licence in Lithuania was issued 1992.06.04 by Lithuanian Communication and Transportation Ministry to the joint stock company of Lithaunia and Luxemburg „Comliet“. Licence was issiued for 10 years period for the price 884,000LTL. For the next 3 yeras „Comliet“ was leading mobile communication operator in Lithuania with network covering about 80% of state territory. However with the introduction of GSM technology it‘s share started to decilne significantly and in year 2000 „Comliet“ was acuired by local fixed telephony monopolis „Lietuvos Telekomas“. Currently „Lietuvos Telekomas“ operates „Comliet“ as a fixed line telephony substitution provider, where due to infavourable conditions is not possible to have traditional fixed line telephony. First 2G mobile communication GSM DCS 900 licence in Lithuania was issued 1994.10.25 by Lithuanian Communication and Transportation Ministry to the Joint Stock Company „Litcom“ which was later renamed to „Omnitel“. Currently „Omnitel“ is leadind mobile communication network operator. Second 2G mobile communication GSM DCS 900 licence in Lithuania was issued 1995.05.09 to the Joint Stock Company „Mobilios telekomunikacijos“ which was later renamed to „Bitė GSM“. Currently „Bitė GSM“ is one of the 3 mobile communication operators in Lithuania with market share... Due to vast network expansion and excessive number of subscribers growth „Omnitel“ and „Bite GSM“ in 1997 requested second GSM DCS 900 licence. The where where issued with the second licence on 1997.10.31. Each of the licences was issued for 10 years with fee 884,000LTL. 1998.02.23 proposed a tender (based on „beauty contest“ model which wil be examined with more details later in the master thesis) for GSM DCS-1800 licence.1998.09.23 thee winners where anounced: „Omnitel“ , „Bite GSM“ , „Levi and Kuto“. Joint Stock Company „Levi and Kuto“ was later renamed to Tele-2. Tele-2 currently is second bigest mobile communication network operator in Lithuania with market share.. 2000.12.29 „Tele-2“ was issued with the DSC 900 licence. All mentioned licences tradionaly issued for 10 years period for 884,00LTL fee. 3G licences in Lithuania are currently not issued. 14
  • 16. 2. Internal - structural factors influencing growth In the following section various sources of network effect literature are summarized. For the master thesis two main groups of authors where chosen: traditionalists, which started developing network effect concepts in the 5th – 6th decade of the 20th centaury and few relatively young and modern authors from the 9th decade of 20th centaury who are currently trying to renew and supplement traditional concepts. 2.1 Network effect 2.1.1 Michael L. Katz and Carl Shapiro It seems rather logical to start analyzing and reviewing literature on network effect from the mostly quoted paper of this subject – “Network externalities, competition, and compatibility” by Michael L. Katz and Carl Shapiro. This was one of the first papers which described network effect in a fashion which is commonly used today. Katz & Shapiro (1985) observe that “there are many products for which the utility that a user derives from consumption of the good increases with the number of other agent consuming that good”. Authors of the paper were one of the first to give reason for positive consumption externalities arising in the network. In the following section author of the master thesis intends to relate these reasons with the main topic of the thesis: 1) Direct physical effect which increasing number of purchasers has on the quality of the product. Quality in this case means, that as more agents join, more convenient and applicable service becomes (in case of mobile telephony, as number of mobile phone users increases, the incentive for new potential users to join also increases). 2) Indirect effect arising from hardware – software paradigm. As number of mobile phone subscribers increases, network operators create and provide more and more additional services (for example SMS, fax, email, MMS) which are also incentive to join. In case of 2.5G and 3G these services can be provided not only by network operators, but by external service providers, which will mean even more additional and attractive services and applications. 3) Post purchase service development. 15
  • 17. As current mobile communication networks in most countries do have full coverage of the area, post purchase services are usually highly developed for most of the network operators. Some post purchase services, such as handsets or prepaid SIM cards distribution, are provided by other retailers which are not connected to network operators. This also has big impact as positive network externality for mobile communication market. Also Katz & Shapiro (1985) state that “For communication networks, the question is one of whether consumer using one firm’s facilities can contact consumers who subscribe to the services of other firms”. This is applicable to mobile communication networks, because current networks are interconnected nationwide and worldwide with global roaming system. But also we should not forget that international calls are still relatively costly service, when compared to local calls. It’s rather obvious that in the future cost of international should decrease significantly and this will also serve as even more powerful consumption externality. Despite the fact that quoted paper already is two decades old and was written in significantly different technological environment, it seem that it’s findings are universal and can are applicable today. Katz & Shapiro (1986) also provide us with the findings about technology adoption in industries where network externalities are significant. Author of the master thesis intends to link some of these findings with relevant examples about the current situation in the 3rd generation mobile communication industry, where 5 incompatible standards (WCDMA, CDMA2000, TD-SCDMA, UWC-136, and DECT) for possible technology adoptation are present: 1. Compatibility tends to be undersupplied by the the market, but excessive standartization can occur. This is very the case for a current situation of technology adoptation in 3G phones market. Despite the fact, that 5 major 3G standarts are present, major mobile phone producers (Nokia, Motorola, Sony Ericsson) are revealing handsets for only WCDMA standart, as most network operators which are starting to provide 3G services have chosen WCDMA platform for the current implementation of 3G. This does not mean, that other standarts will be forgotten (maybe they are under development or will be developed for the future 3G), but up to date WCDMA has established itself as a leading 3G standart. 16
  • 18. 2. In the abscence of sponsors, the technology superior today has a strategic advantage and is likely to dominate the market. According to this finding, WCDMA is superior today even without major sponsoring activities and will dominate 3G market in the nearest future. This seems rather likely, because if the WCDMA technology will work as it is intended and will assure qualitative services according to 3G specifications, there will not be much incentive for network operators to invest in the creation of the networks based on other competing standarts. 3. When one of two rival technologies is sponsored, that technology has a strategic advantage and may be adopted even if it‘s inferior. This might be applicable to WCDMA case – other competing standarts might be have technical implementation advantages, but as WCDMA was chosen by most important network components and handsets market players (for the reasons which remain unknown), it is cleat that this technology has a strategic advantage. 4. When two competing technologies both are sponsored the technology that will be superior tomorrow has a strategic advantage. In the 3G market is also applicable, because major network equipment and handset producers might have chosen WCDMA as a leading standart, because they see that WCDMA technological capabilities assure it‘s ussage in the future. Katz and Shapiro (1994) also examine network effect in the presence of systems competition. First of all let’s look at how authors of the paper define concept of systems: “Many products have little or now value in isolation, but generate value when combined with others. <…> Products are strongly complementary, but they need not be consumed in fixed proportions. We describe them as forming systems, which refers to collections of two or more components together with an interface that allows the components to work together.” Authors also separate two types of defined systems: • Communication networks. • Systems based on hardware software paradigm. Communication systems allow various users exchange specific type of messages when they join the system, which provides the “interface”. Interface is usually created and owned by service provider and a tool, a component to access the network might be property of user or 17
  • 19. provider. Obviously in case of telecommunication, that interface is network and components are the phones. Concept of systems might define fixed telephony as well as mobile communication industries. Software - hardware paradigm systems both interface (hardware) and value providing component (software) are usually purchased by the user (for example PC hardware and software or CD player and audio CD’s). In some cased “hardware” might be sold under its production costs and producers get its revenue from the sales of “software” (for example Microsoft sells Xbox gaming console for ~50% of its production costs). Typically both types of systems demonstrate observable presence of network effect. In case of communication network systems “value of the membership to one user is positively affected when another user joins and enlarges the network”. This is rather usual description which can traditionally be found in most research papers of Katz and Shapiro. But network effect in hardware software paradigm network is described differently: consumers form the expectation about which systems are going to be popular and by buying software they encourage the producers to achieve economies of scale, which is also specific type of network effect (value obtained from the network increases as more users join). Also authors point out three main features of systems competition: • Expectations • Coordination • Compatibility Rational expectations users form expectations about availability, price and quality of the components they will be buying in the future. This effect is more obvious in case of software hardware paradigm, because here users purchase “interfaces” themselves, but effect can be observed in communication systems as well. In communication systems switching costs also exist – usually access to the network is not granted for free, for example mobile phone users must buy SIM card, fixed line phone users must pay phone line installation fee. System markets also set challenges for the producing firms. Manufacturers taking part in both type’s systems components and interface production must coordinate their action with other components and interface producers as well. It is rarely the case when one producer can successfully produce both interface and components of the system. Also the significant role there is played not only by the market forces, but also by various industry-wide standard setting bodies. The impact of standard setting bodies in case of mobile telephony was addressed in first part of the master thesis. 18
  • 20. Issue of compatibility between systems is also addressed by the authors, but in rather original manner. Katz and Shapiro (1994) reject the idea that “incompatibility is just another coordination failure”, and claim that “obtaining and maintaining compatibility often involves a sacrifice in terms of product variety or restraints on innovation”. This idea could be used when analyzing two different cases of introduction of new generation mobile communication systems, because Katz and Shapiro (1994) pointed out that ”Incompatible systems also can represent different generations of a single core technology”. So when second generation mobile communication “interface” was introduced, it’s components (mobile phone) where not compatible with first generation standard interface, but currently third generation mobile phones are usually compatible with the existing second generation networks interface. Few reasons explaining such situation might be pointed out: • First of all, technically first generation and second generation where completely incompatible due to very different technology. • Secondly, third generation services are seen as addition to main second generation services, usually still within the limited area (highly populated territories) and available only for those who have technically advanced expensive mobile phones. This could argument could be also supported support by Katz and Shapiro (1994) finding: “If the rival systems have distinct features sought by certain consumers, two or more systems may be able to survive by catering to consumers who care more about product attributes that network size.” • Thirdly as network operators have made huge investment in to existing second generation networks, they upgrade current network component to fit third generation network, thus experiencing economies of scale, while it is rather costly for the new operator to enter the market and establish himself as new provider of third generation network. So can be said that first and second generation could be called incompatible systems, while second and third generation systems are compatible. But according to incompatible systems definition by Katz and Shapiro “two communication networks are incompatible if subscribers on one network cannot communicate with those on other networks”, we could say that any generation mobile communication generation users can reach any other generation users by voice calls; moreover they can communicate with totally different system – fixed telephony network. Author of the master thesis would suggest update the concept of incompatibility in following way “two communication networks are incompatible if subscribers on one network 19
  • 21. cannot communicate in any existing network interface using any existing network component”, because as in this case systems might look incompatible, but actually their interfaces are be linked. 2.1.2 Stan Liebowitz and Steve Margolis Two of these modern authors, who question „classical“ network effect paradigms and search for more applicable models are Stan J. Liebowitz and Stephen E. Margolis. In their network externalities and network effect definition, included as entry in „The New Palgraves Dictionary of Economics and the Law“ authors primarily are trying to separate widely used concepts of „network effect“, „network externalities“ and define them more precisely: „The enthusiasm for recognizing and understanding these phenomena should not, however, lead us to inappropriate or premature conclusions. As we have noted above, there are distinctions and reservations that ought to be maintained. The first and broadest is that between network effects and network externalities. A further distinction is between pecuniary externalities and real ones. Even for the set a real externalities, it is important to note the distinction between the problem of network size and that of network choice, the boundedness of the network effect, the likely symmetry of network effects for alternative products, the ability of large consumers to self-internalize network effects, and differences in tastes. Liebowitz and Margolis (1995) explain term “network effect” in following manner: “The circumstance in which the net value of an action (consuming a good, subscribing to telephone service) is affected by the number of agents taking equivalent actions will be called a network effect” Author claim, that term “network externality” should be used to describe specific kind of network effect, where “equilibrium exhibits unexploited gains from trade regarding network participation”. People when making a decision about joining a specific network (for example telecommunication or computer operating system) always inevitably consider how their participation will affect others and how the participation of others will affect us, meaning that people consider what the people around them are choosing or are likely to choose. Liebowitz and Margolis (1995) critically observe that so far the term “network externality” in the research literature was always associated with positive effect, but that is only one part of the picture. Negative effects caused by network externalities are also a part of our lifes, for example when telecommunication or computer network reaches state of overload, any new 20
  • 22. user joining the network will only decrease the utility of other user which they derive from the consumption. Also there are network, where willingness of other people to join the network harm each others interests – for example excessive demand for housing in particular area causes price bubble thus making people pay more than they initially expected. This understanding of network externalities expands areas of definition usage significantly when compared to the definition of Katz and Shapiro. Liebowitz and Margolis (1995) summarize that “goods exhibit network externality wherever the consumer enjoys benefits or suffers costs from changes in the size of an associated network, that is, changes in quantities demanded”. Authors notice that benefits and costs resulting in such situation are directly connected to compatibility, brand familiarity, product information, status, service availability or the prices of network related goods. Also Liebowitz and Margolis (1995) add one more interesting dimension to the Katz and Shapiro classification of networks of communication networks and networks based on hardware – software paradigm (discussed earlier in the master thesis). Authors also classify networks according to the ownership of network itself. They notice that in the communication networks “participants are literally connected to each other in some fashion”, where network creation requires investment of capital and property rights are always established for such networks. In such networks users join only with the permission of network owner and use network according to provided rules. Obviously mobile communication networks belong to described category. Other type of networks, which correspond to Katz and Shapiro hardware – software paradigm model, are named by Liebowitz and Margolis as "metaphorical networks" which are described as providing interrelationships in with no physical connections used. These networks are not likely to have an owner, because usually it is not possible to have one. Example could be drivers of particular car brand. 2.1.3 Other authors Despite the fact that Michael L. Katz and Carl Shapiro works on network effect and network externalities are widely acclaimed as classical, after some time other authors are trying critically review all the findings which others authors have made and explain areas of the theory, which are not completely covered or lack real life evidence. Master thesis author intends to include few example of such critical approach; one of them is Tim Weitzel, Oliver Wendt, Falk v. Westarp recent paper “Reconsidering network effect theory”. 21
  • 23. The authors claim that: “While the traditional models greatly contributed to the understanding of a wide variety of particular (macroeconomic) problems associated with the diffusion of standards, they fail to explain the phenomenological variety of diffusion courses in today’s dynamic information and communication technology markets.“ Authors remark that current network externalities theory does not cover the heterogeneous properties of the markets with new products such as digital television, cellular phones, office software, Internet browsers, EDI-solutions. These are the markets and products, which where not present during the time when “classical“network externalities where examined and need further researches. In the article, authors try "Systematically reveal deficiencies in the models of positive network effects by analyzing common assumptions and conclusions, before extending this criticism to the more general premises of the neo-classical framework.“ 22
  • 24. 2.2 Diffusion of innovations According to Encyclopædia Britannica2 diffusion of innovations definition: “Some social changes result from the innovations that are adopted in a society. These can include technological inventions, new scientific knowledge, new beliefs, or a new fashion in the sphere of leisure. Diffusion is not automatic but selective; an innovation is adopted only by people who are motivated to do so <…> Many innovations tend to follow a pattern of diffusion from higher- to lower-status groups.” Also mentioned higher status is defined as “young, urban, affluent, and highly educated, with a high occupational status. Often they are motivated by the wish to distinguish themselves from the crowd. After diffusion has taken place, however, the innovation is no longer a symbol of distinction. This motivates the same group to look for something new again.” 2.2.1 Everett M. Rogers Everett M Rogers in his book “Diffusion of Innovations” defines the diffusion of innovations process saying that innovation is usually communicated “through certain channels over time among the members of social system”. This means that four key elements are part of the diffusion process: • innovation – a product or other objects which is perceived by an individual as new; • communication channels - intermediary by which messages sent from one individual or group reach another individual or group; • time – two time periods are present: innovation-decision process time and an individual or group innovation adoption process time; • presence of social system social system. Moreover Rogers (1963) segments of population which take place in the diffusion process with their characteristics: • Innovators - daring and the risk tolerant individuals with substantial financial resources to absorb possible loss from an unbeneficial innovation. They are intelligent, have ability to understand complex technical issues and do not feel uncomfortable with uncertainty of innovation; 2 http://search.eb.com/eb/article?tocId=222921&query=diffusion%20of%20innovations&ct= 23
  • 25. Early adopters – usually they are well integrated part of the social system having great degree of opinion leadership. They are viewed a role models, are respected and successful; • Early majority group is described as interacting frequently with their peers, but rarely hold positions of opinion leadership. They are rather conscious before adopting a new initiative and constitute to about one-third of the members of a system, thus making the early majority the largest category taking place in the innovation diffusion process; • Late majority also counts for about on third of the population. They adopt innovations by receiving pressure from peers or because of economic necessity. They share characteristics of being skeptical, and very suspicious. • Laggards group hold no opinion leadership with point of reference in the past with limited financial resources. Actually this segmentation is very applicable to the diffusion process of mobile communication looking at the markets where mobile communication gradually established itself going through all technical generations. Innovators where the first users, usually financially unrestricted and interested in new technology, who purchased first extremely expensive mobile communication sets and paid very high price for the services. At this stage mobile communication was very niche market. After that, the wave of early adopters followed when network coverage became larger. It was mostly institutional and business users. The only distinction between the early majority and late majority in this case could only be the difference of financial abilities, because after the technology has advanced, it was only a question of time when it will became cheaper and will be accessible to most people in most countries. This segmentation of course is relevant in the countries where mobile communication was introduced gradually, because countries which adopted already developed mobile communication technology (for example developing countries adopting networks of 2G) are in little different situation, when users adopting the technology do not take any adoption risk. The technology is already tried in other countries and they potential adopters know technology usability. This means that in such countries only two major groups could be observed: early majority and late majority, which only differ by financial limitations. But in this case question arises whether it is really a diffusion of technological innovation. When product is introduced in the new market not from the first stage of its lifecycle, different analysis of adoption is required. 24
  • 26. In addition Rogers (1963) points out five stages of the innovation adaptation process. The five stages are: • awareness is described as a stage, where individuals are directly exposed to the innovation although they lack complete information about it; • Interest stage starts when an individual becomes interested in the new product or technology and sees additional information about it. • Evaluation stage starts when individual psychologically applies the innovation to his predictable future situation and then makes a decision to try it or not. • trial stage is considered a period when individual tries to get full use of the acquired innovation; • Adoption stage is defined as a moment when the individual makes a positive decision about continues full use of the innovation. 2.2.2 Bass model Mahajan and Muller (1979) claim that objective of a diffusion model is to present the level of reach of an innovation among a potential adopters over time. Moreover the rationale of the diffusion model is to show the successive increases in the number of adopters and forecast the continued advance of a diffusion process already in evolution. In the product innovation perspective, diffusion models focus forecasting first-purchase sales of innovations. They also might serve for the development of product life cycle. Mahajan et al. describe diffusion models as “first-purchase models” assuming that in the product life cycle timeline there are no repeat buyers (this means that number of buyer is equal to the quantity of sold product). The best known and most basic first-purchase model of new product diffusion was defined by Frank M. Bass (1969). Main idea of the Bass model lies in assumption that potential adopters of any innovation receive influence influenced by two means of communication: • mass media • word of mouth 25
  • 27. Basically model assumes two groups of potential new technology adopters take place in the diffusion process. One group receives influence only by external influence channels – mass media communication. Another group is a subject of internal influence – word of mouth communication. Bass names the externally influenced group "Innovators" and the internally group "Imitators". It is important to observe that the role of the groups in the diffusion of innovation process differs by the timing of the involvement. Innovators are first to receive information about new product and do have financial means t purchase it and ability to use independently. This is rather similar to the definition of Rogers (1963). However imitators are influence by personal connection with the innovators and in this manner the diffusion happens. Bass model conceptual structure is graphically depicted Figure 3.1. Two curves depict noncummulative dynamics of technology adoption by making difference between Innovators and Imitators. Despite the assumption that innovators are usually the early adopters, however decreasing percentage of the does exist throughout all the time period. However it is not clear how some individuals can still be influenced only externally when the curve of internally influenced users reaches its peak. Also one more questionable assumption of Bass model is observed by Mahajan et al. Technology adopter distribution assumes that an initial pm (a constant) level of adopters buy the product at the beginning of the diffusion process. Once initiated, the adoption process is symmetric with respect to time around the peak time T* up to 2T*. That is, the shape of the adoption curve from time T*to 2T*is the mirror image of the shape of the adoption curve from the beginning of the diffusion process up to time T*”. Usually it can be observed that after the number of adopters reaches peak, market saturation level is not far away. This means that after realistic curve should have much higher slope after the peak point in the graph. Simplified Bass model calculating the total number n of technology adopters in time period t is expressed by the following function: n(t) = p + q Where p is a number of innovators (which is calculated by knowing “coefficient of innovations” – proportion of the potential innovators within population) and q number of imitators (which is calculated knowing “coefficient of innovators”. Time dimension by having different time periods for the innovators and imitators is added for more exact calculations. However it is rather unclear how accurate coefficients of potential innovators and potential 26
  • 28. imitators can be objectively obtained in the real product market. Bass model is extensively quoted, interpreted and expanded in the innovations literature during last three decades. Few interesting extensions of the model are provided below. Tanny and Derzko (1988) imply that concepts of „Innovators" and "Imitators" used in Bass model do not precisely describe characteristics of buyers taking part in the technology adaptation process. They offer an addition of the model in which all potential adopters are divided in two distinctive groups which they label “Potential Innovators” and “Potential Imitators”. Potential Innovators as well as Potential Imitators are a subject of the mass-media communication influence, but only Potential Imitators are influenced by word of mouth, where Potential Innovators are free of this influence. This seems really reasonable, because Potential Imitators also receive also receive external mass media influence, but it might be, that this influence has different consequence on their decision making process. Also as it was pointed out by Rogers (1962) it might be that different groups might receive different quality of external media provided information (for example people with more financial resources do have access better quality information channels – satellite TV, international press). One more interesting observation was made by Mahajan et al. (1990). A key characteristic of the Bass model is that it addresses the market in the aggregate manner, measuring the number of two groups adopters who acquire the product in time period t. Mahajan et al. (1990) raises subsequent question: “Can the diffusion model be built by aggregating demand from consumers who behave in a neoclassical microeconomic way? That is, assume that potential adopters are smart and are not just carriers of information. They therefore maximize some objective function such as expected utility or benefit from the product, taking into account the uncertainty associated with their understanding of its attributes, its price, pressure from other adopters to adopt it, and their own budget.” This means that every single adopter both from imitators and innovators groups do have more characteristics that it is taken in to account in the Bass model. That it is why one more dimension should exist – it is probability of adopting the product in time t for consumer with its specific characteristics. Mahajan et al. mentions several parameters which could be added to the Bass model: individual uncertain perception of the innovation's performance, predicted future value and benefits from the innovation. So only by looking at the micro level of 27
  • 29. potential adopter, we can assume that individual will adopt the innovation when “his utility for the innovation becomes greater than the status quo (he is better off with the innovation)”. 28
  • 30. 2. External – regulation factors influencing growth In this section three articles three relevant articles are analyzed. John Kruse article discusses the methods of conducting spectrum allocation. Harald Gruber article analyzes the role of the regulation in the process of growth. This article provides us with the alternative example of spectrum allocation in Hong Kong. 3.1 Methods of allocation of scarce resources The study of Jorn Kruse (2002) examines various methods and options available for the allocating scarce spectrum resources. Brief summary of the discussed methods is provided below. Kruse (2002) already in the introduction mentions that current developments of the mobile telephony market can be characterized by low level of regulation in most countries, only with significant exception of spectrum licensing. Also he ads, that spectrum allocation methods by large shape industries and market structures in the individual countries and as spectrum is a scarce resource, it is very important that allocation lead to desired results of the efficiency of competition in the market. Author remarks that “Spectrum is not only a technically essential resource. The availability of more or less spectrum (and what kind of spectrum) is of primary importance for the economic success of a mobile operator. Adequate spectrum allocation is a crucial factor, if a mobile sector will be competitive and efficient or not.” Kruse (2002) emphasizes the role of government (spectrum regulating body) in the process, because its action has a strong impact on important characteristics of the market: the number of the markets players, standards, competition rules etc. Also author ads that spectrum can be described as an essential resource and the allocation of spectrum is really significant for the level of competitiveness of operator and has an impact on the competition and the efficiency of the whole industry. Kruse (2002), before going into details of various spectrum allocation methods, explains important the concepts of Intramodal and Intermodal Spectrum Allocation. 29
  • 31. Term Intramodal Spectrum Allocation is used to describe the rivalry between similar services operating within the same frequency thus creating the situation when spectrum becomes subject to consumption rivalry. Intermodal spectrum allocation describes the allocation of spectrum to different services (TV, cellular mobile communication, or emergency). The allocation of the intramodal spectrum dimension is traditionally decided by regulating body. However in the literature ideas promoting the free market standardization process can be found. Following methods for Frequency Resources Allocation are used by various countries regulating bodies: 1. First-come-first-served was most commonly used during early days of telecommunication, when monopoly situation existed. Companies (usually state controlled) where granted with the licenses without any competition. It was just a bureaucratic procedure without any intervention of the market forces. Nevertheless this allocation method was mostly used for the first generation mobile communication, but also in some countries first generation license holder was granted with the second generation license. However this method is not practiced in the market economies nowadays. 2. Lotteries method also is rather rare case, but I was used in United States local digital markets, because the procedure is very simple and rarely a subject for legal complaints. However method does not warrant efficient use of spectrum, because second hand trade even prohibited by the regulators might take place using license holding company acquisition. 3. Auctions are most commonly used method nowadays for spectrum allocation, because they have characteristics of being non-discriminatory and transparent. Also depending on the auction design they have relatively low transaction costs. As the market forces operate in this method, it is most likely that it will lead to the efficient use of spectrum. Also auctions are not very vulnerable for the potential corruption because influencing bodies do not leave much of discretionary control. Sometimes (as with the most European 3G licenses) they are seen as a source of significant contributions to the countries’ budgets. Auction designs can have few forms according to their institutional settings and rules: 30
  • 32. The English Auction is most standard auction procedure also commonly used in all other market niches where auctions are conducted. It starts from a low price, when a bidder overbids the prevailing bid in each round. Auction ends when no higher price is offered and the remaining highest bidder is getting the license at his offered bid price. However the relatively simple procedure might become complicated when more than one license is offered simultaneously (frequencies in different regions). • The Dutch auction is an opposite way when auction starts from a high price, which is automatically lowered if no bidders stop descending procedure. • In the First-price sealed-bid-auction mechanism the bidders to submit a single (non- renewable) bid. The highest price bidder gets the spectrum license at his offered price • In the Second-price sealed-bid-auction or Vickrey auction, the winner pays the price of the second highest bidder. However most auction researchers agree that even simple auctions mechanisms are subject to the risk of collusion, depending on the specific auction method. Even in the English auctions, where it looks like incentives for cheating are almost non-existing, comparatively high risk of collusion exists. By saying that Kruse (2002) remarks that most of European spectrum auctions have been English auctions. 4. Discretionary decision making is method which is fiercely criticized by free market economists’ because it usually is associated with corruption and fraud, as the regulating bodies have highest authority to choose the winner according to heir own standard. It might happen that these standards are set favorably for the companies which support ruling parties financially or even to family owned companies. Despite the fact this that most discriminating and intransparent it is still practiced in some African countries. 5. “Beauty Contest” is procedure when potential candidates are evaluated on clear and transparent criteria by government regulating bodies or independent commissions. Sometimes this method includes auction elements or might serve for the creation of potential candidates list (Honk Kong spectrum licensing case will be discussed later in the thesis). 31
  • 33. Kruse (2002) concludes the discussion about spectrum allocation mechanisms by stating that “In general, economists strongly advocate auctions. But in practical terms, this very much depends on the specific institutional framework and action design.” Kruse (2002) also criticize European 3G license auction by saying that in spectrum auction, unlike in other traditional market transaction where auction are employed, the objective should not be the maximization of revenues, but “The proper functioning and efficient outcome of the mobile markets are supposed to be the main objectives for the spectrum and licensing auctions”. European 3G licensing will be discussed in more details within this thesis. Author also suggests questions which should be taken into account when developing a spectrum allocation mechanism. They should include: • Length of license duration and renewability. • Spectrum tradability on a second hand market. • Time schedule of auctions in relation to technological and market developments. • Step-by-step-licensing or simultaneous licensing in the market. • Advance notification of participation in the auction. 3.2 Role of regulation Harald Gruber (2000) in his articles tries to answer the question what impact does the scarcity of frequency spectrum makes on the performance of the mobile telecommunications industry. Also in the paper author provides insights about the role of spectrum allocation together with most important developments during the existence of spectrum allocation period. Brief summary of the most relevant points of the article is provided below. Author starts the article by emphasizing the importance of spectrum allocation in nowadays mobile communication industry. The competition for the scarce frequency resources started when first non monopoly operators where allowed to act as service providers. Despite the fact that mobile telecommunications industry is constantly improving the spectrum efficiency used for the services, the increasing popularity of mobile telecommunications services puts on additional pressure for allocating even more frequency spectrum. Also as mobile 32
  • 34. telecommunication is highly profitable business, with financially powerful operators, spectrum licenses are becoming continue sly expensive. Gruber (2000) reminds that from the of telecommunication industry, mobile communication was seen as a natural monopoly, for the rational reason, that due to technically not advanced systems, frequency spectrum availability was very scarce with poor efficiency of resource usage. But regulators and other public bodies became more and more concerned that the absence of competition in the industry leads to inadequate incentives to decrease costs and also provides no suitable environment innovation with observable under-investment. Frequency competition was born after the introduction of more advanced second generation mobile communication systems, when some countries started issuing more than one license for the providers of mobile communication services. After that the idea of fees for issuing the licenses came into place. Thus mobile communications industry became the first major space of competitive supply of telecommunications services. Gruber (2000) claims that government licensing policy in mobile telecommunications has following dimensions: 1. Government needs to make decision about a single national standard or leave this decision for the market where multiple technological systems can compete. 2. Government need to define the optimal number licenses to grant as well as timing on issuing 3. Government needs to develop suitable licenses allocation method. In the beginning GSM licenses were allocated mainly using “beauty contests” allocation method in Europe. Also in some countries incumbent fixed line telecommunications operators where granted with the licenses. However it was obvious that it can be only a temporary solution, because as the market labialization was increasing (mainly due to impact of the intereueopean regulation) competitive interaction among bidders was constantly increasing. Gruber (2000) provides reflection of these trends using statistics about various countries telecommunication sector: from 118 countries which adopted first generation mobile communication systems 75% had monopoly, while from the 87 countries which adopted second generation mobile communication systems 56% already had oligopoly. Interpreting that Gruber (2000) makes an implication that “Capacity thus seems to be a first crucial factor in explaining the effects of competition on the diffusion of mobile penetration. 33
  • 35. When capacity is constrained, as under the analogue technology (especially during the early years), the effects of competition on mobile penetration are likely to be modest. The effects of competition are potentially much larger under the digital technology when capacity constraints are relaxed.” Gruber concludes the article by saying that the scarcity of frequency spectrum is still the major concern of the mobile telecommunications industry. Despite the significant technological progress that industry made during last decade, scarcity of the spectrum still has limitation for the providers of the services. 3.3 Alternative approach This research paper of Xu Yan (2004) is reviewed in this master thesis as unique and successful example of alternative approach of spectrum allocation. Hong Kong‘s spectrum regulating body Office of Telecommunications Authority after intensive debate and consultation formulated 3G licensing scheme, which is very different from the traditional spectrum licensing auctions used in Europe. Brief review of these differences and steps which where taken upon reaching the unique solution is provided flowingly. In the beginning of the research paper Xu Yan (2004) discusses difficulties, risks and constraints which are inevitable when conducting spectrum auction in traditional manner. These will not be reviewed there as it was discussed earlier in the thesis. Also Xu Yan (2004) ads an interesting perspective of the problem by stating that the difficulties of formulating a harmonizing licensing framework primarily are caused by different economic backgrounds and existing spectrum allocation situation which determine aspects of future spectrum allocation. Analyzing the mentioned economic backgrounds and existing spectrum allocation situation Xu Yan (2004) remarks that Hong Kong government (unlike some governments in EU) has no need to raise significant revenue through spectrum auctions and can trade spectrum at relatively liberal pricing scheme. This gives two benefits: 1. Licenses can be obtained not only by the most financially powerful operators. 2. Companies which get the licenses are not financial exhausted and can invest in to R&D for more innovative new services or have services provided at lower prices. 34
  • 36. Xu Yan (2004) also insists that that 3G as a high-tech value adding industry with social benefit much higher than the commercial benefit and will produce significant externalities if any unfavorable situation developed. That‘s why government should take actions to reduce the risk of potential investors. The most appropriate for the government for reducing the risk is reducing operator’s financial risks by using convenient license pricing. Knowing that Office of Telecommunications Authority eventually rejected primary proposal of auctions and started the discussion about how the spectrum allocation process might be constructed. At first it was only agreed that the practice that traditional procedure similar to ‘beauty contest’ will be used for formulating the potential license candidates list. Also Xu Yan (2004) mentions that the allocation of radio spectrum was a non complicated issue in Hong Kong, because most of the 3G defined spectrum has not been occupied by other services and four 3G licenses can be issued. However four 3G licenses is relatively small number taking into account that where issued 11 licenses in Hong Kong 2G market. The idea of the proposed solution how to deal with this problem came originally from Europe – model very similar to Mobile Virtual Network Operator concept (which exists in EURO) was offered. Mobile Virtual Network Operator is based on the idea that some operators which do not have assigned radio spectrum can use the proportion of spectrum of original Mobile Network Operators and be allowed to build and operate parts of the networks which do not require the use of radio spectrum. When this solution is used Mobile Virtual Network Operator are able to offer 3G services using their own brands but not operating the radio networks, thus reinforcing the competitive market model even more. It was proposed that successful bidders which will be granted with the licenses will have the obligation to open at least 30% of their 3G network capacity for usage of non-affiliated Mobile Virtual Network Operator companies and/or content providers. Concerning the pricing of licenses it was decided that price of the license should be negotiated commercially. Only If commercial negotiation are not successful, the regulator has the right to make own determination based on principles of fair interconnection, thus finding a balance between to low price (‘‘free-rider’’ phenomenon) and a sufficient investment return on cost of capital ( thus reflecting the higher risk of 3G service investment) . Mobile Virtual Network 35
  • 37. Operator and content providers will buy negotiate the tariffs with Mobile Network Operator. Negotiated tariffs might be a subject of regulators intervention and should reflect mentioned return on the cost of capital. Also the pre-qualification process was presented which was intended to be relatively liberal, involve setting minimum criteria on investment, network rollout, service quality, financial capability. Moreover very original license pricing scheme was introduced. Bidders where asked to bid for a level of annual royalty (as a percentage of turnover) from 3G services network operations. However for the first 5 years of operations, minimum royalty payment will fixed by the government, because it will be complicated to distinguish between second- generation mobile service (2G) and 3G network revenues, as most of 3G licensees will be an existing 2G operators. Starting from year six to the end of the license period, 3G Mobile Network Operator will pay royalties to the Government according to the royalty percentage which is determined by the auction. The calculate actual royalty payment of course will different for different Mobile Network Operator as they will have different 3G revenue turnover. Concluding the research paper Xu Yan (2004) states that „It is important to point out that the open network obligation of 3G licensees has been fully debated before the licenses were auctioned, and all bidders have been very well informed about the potential competitiveness of the 3G market. As a result, no bidders should be so nave as to unreasonably overbid the licenses, especially in the context that several European licensees are suffering from the winner’s curse. “ In this way government also is not losing either, because the continues royalty payments will allow the government strengthen possibly unstable future 3G services market with almost no financial risk. Hong Kong’s 3G licensing scheme might be seen a balance between scarce spectrum efficiency and working market competition thus providing an alternative way of thinking about the problem. 36
  • 38. 4. Empirical analysis 4.1 Example of empirical research 4.1.1 Massini’s research Massini’s (2004) study investigates the diffusion of mobile telephony in Italy and UK using the 1990s. Massini used the following data variables for its research: • Subscribers Monthly series • Tariff Average annual revenue per subscriber • Price of the Handset • Final Consumption Expenditures, • Consumption Price index to deflate the series of the price of the • Active population Author defines an aggregated diffusion model, based on the standard epidemic model, by introducing economic variables. In addition to the economic variables authors also ads variable that takes into account the effect of the technological change which occurred in mobile telephony during the researched period. This change was the shift from analogue (1G) technology to digital (2G) technology. This variable also might be interpreted as a factor for quality changes. In the paper author defines and estimates diffusion curves of mobile telephony users in Italy and the UK during the 1990s, using standard epidemic model and taking into account of economic and technological factors that are helpful in explaining differences of the diffusion speed. Also they suggest methods to differentiate long-run relationships and short-run adjustments of continuous diffusion. Interesting remark is that, two countries have very similar characteristics (size, wealth, population and geographical features), exactly the same mobile telephony services introduction year (1985). Even so investigation market structures and institutional regulation frameworks, shows remarkable differences in two countries: Italy had near monopoly situation until the introduction of the second operator in 1995, while in the UK the service where started from duopoly model which was enriched by the entry of a two more operators in 1994. Also author notices, that the strategies local mobile network operators employ, shows observable differences in Italy and United Kingdom. Italian operators where primarily competing by introducing innovative pricing packages, including the introduction first 37
  • 39. prepaid SIM card in 1996. British operators chose to use subsidies for the cost of the handset thus locking customers to their networks. This resulted in differing portfolios of clients in both countries with different tariff packages in both countries: • Large number of prepaid cards and pay as you go contracts, which do not require high connection fees. • Large number of subscribers to knowing their own needs and operator’s characteristics with discouragement to switch network. Massini (2004) remarks that “Although the prepaid customers tend to spend less than contract customers and reduce the average revenue per subscribers, the success of prepaid services in Italy and UK has been such that the total profits for the operators are growing continuously.” Also author insists that improved marketing of services and information presentation was employed by the operators because of constantly increasing variety of products and services which ads substantial complexity and confusion when buying a mobile phone. Before conducting the empirical investigation, author extensively explains the diffusion process of S-shaped profile by describing to counteracting forces involved in the process. First force is the increasing number of the adopters which acts positively on the diffusion; the second force is decreasing number of potential adopters. Author also notices that “the epidemic feature is not simply spread of information about the existence of the innovation, but also spread of information concerning its technological characteristics and the increase in post-adoption profitability”. This can be seen as a wise strategy for the developers and promoters of any innovation: it is necessary to reduce the potential adopters decision making process by reducing degree of uncertainty associated with the innovation. As more information about the innovation is available from various sources, critical mass of the adopters is reached. Massini (2004) finds out those profiles of the number subscribers of mobile telephones shows typical S-shaped curve both for Italy and the UK. Also author observes that number subscribers of analogue first generation technology reached its maximum saturation level both in Italy and the UK in 1996, after which the decline follows. As it is typical for competing product generations the two technologies had showed same market shares in 1997, but in both countries analogue telephones started to disappear while digital telephones have grown even faster after that. 38
  • 40. Also author remarks that from the point of view of the operators, the cost of the infrastructure for the digital technology due to some specific technical reasons was lower and required much smaller investment when compared to the analogical technology. This means that service providing even better quality can be cheaper that lower quality old generation service, meaning that there is no real competition between technologies and switching of consumers is only a question of time Author adds that:”The profiles of the subscribers of the analogue and digital technologies follow the characteristic pattern of technological substitution between successive generations of technologies, where a new generation cannibalize the previous one and will be cannibalized by the next generation” Author summarizes the following results of the most important in the researcher: 1. The assumption that the introduction of the digital technology (2G) had a significant improvement for the Italian subscribers, but not significant for UK subscribers is strongly supported by empirical results. Author gives a following explanation to this finding: “If the trend represents learning factors it could be argued that the British market was already quite mature when the digital technology was introduced and the learning processes on the new technology have been increasingly less important. “ 2. Result show is that economic variables have an important in both the diffusion speed and the saturation level. Most important variables where tariffs and price of handset. Price of the handset was less significant in UK that in Italy and this is explained by the fact that handsets are traditionally largely subsidized in UK. Tariffs where highly important in both countries 3. Author applies the Error Correction Model and gets the result which demonstrates “that the variables affecting the diffusion speed tend to be significant in the long run, but they do not affect the process in the short run, and they do not explain the deviations from the long run pattern.” Author suggests for future researchers to add more factors: • market structure; • infrastructure indivisibility; • some characteristics of the handset, 39
  • 41. the coverage rate; • information on the fixed lines, like its relative costs compared to the mobile network; • longer and updated data on the three generations of mobile communication technology. 4.2.1 Botelho research The recent paper of Botelho, Pinto (2004) paper analyses the pattern and rate of adoption of mobile telephones in Portugal. Time-series data on the number of subscribers is analyzed using statistically based method to estimate the market potential for mobile phones is employed, allowing generation of confidence intervals about the estimated market potential. The nature of the used method allows researchers not only to empirically derive the expected market potential, but also to determine the current stage of the market with respect to saturation level and make observations about growth process. Botelho et al. (2004) estimated the S-shaped diffusion functions (exponential, Gompertz, and logistic) growth models using time series data on the number of cellular phone subscribers) by ordinary least squares method for exponential function and nonlinear least squares for Gompertz function. The find out that: 1. Exponential growth model has high coefficient of determination and high t-statistics, but model clearly overestimates number of cellular phone subscriber’s growth rate. Author concludes that exponential growth curve does not provide a very realistic description of the cellular phone diffusion in Portugal. 2. Results using the Gompertz model show that the saturation of Portugal mobile phone users market is 25% than Portugal’s population rate and author declares this as unreasonable suggesting that Gompertz model does not provide accurate forecasts of the growth phenomenon. However article was originally written in 2001 and the last data used is from 2000. Recent mobile phone user’s statistics show that in some countries the saturation level has already overcome 100%. This is possible because increasing proportion of population is using few SIM cards for various purposes. 3. High t-statistics for each of the estimated parameters in the logistic model results indicates an excellent fit with the data. Also logistics model demonstrates a realistic saturation level of 67% of population. 40
  • 42. Author concludes the paper saying that conducted research demonstrates that the adoption of cellular phones in Portugal can be explained by S shaped -curve. Also he ads that “although both the Gompertz and logistic models describe a sigmoid diffusion curve, it is only the logistic model that adequately describes the path of cellular phone diffusion in Portugal.” The reason for this is rather technical: the Gompertz model is derived from a skewed frequency distribution, while the logistic model is based upon a symmetric frequency distribution which fits researched situation much better. Also logistics model depicts the rate of diffusion in Portuguese cellular phone market better because it is closer to symmetric, while reaching its maximum growth at an earlier phase as Gompertz function suggests. Functions Botelho et al. (2004) provides us with the specification of the traditionally used functions which depict S-shaped diffusion process. As author of the master thesis also performs statistical data analysis similar to the one conducted by Botelho et al., overview of these functions with brief descriptions is provided flowingly. Botelho et al. (2004) explains the usage of S-shaped diffusion model in following manner: “Irrespective of the particular account of the diffusion process, the stylized diffusion path of most innovations results from the fact that initially, during an embryonic phase, only a few members of the social system adopt the innovation. Over time, though, an increasing flow of new adopters is observed as the diffusion process unfolds. This is the phase of rapid market growth. Finally, during a maturing phase, the trajectory of the diffusion curve gradually slows down, and eventually reaches an upper asymptote or saturation level.” Traditional evolutionary pattern S-curve is expressed a differential equation: 41
  • 43. Where: • y(t) is the cumulative number of subscribers at time point t; • y* is the saturation level • γ is the coefficient of diffusion. Main assumption of the model is that number of subscribers growth rate is positively influenced by the number of existing subscribers and the difference between the saturation level and the number of existing subscribers. Mostly used functions of S-curves representing are the logistic, the Gompertz and exponential functions. Each of them is described below. The Gompertz function is expressed as _________________________________________________________________________ Where: • yt is the number of existing subscribers at time t; • k; a; and b are parameters to be estimated. The Gompertz function values ranges from a lower asymptote of zero to the upper bound k, while t ranges from negative infinity to positive infinity. The parameters a and b are used for determining the location and the shape of the curve. The logistic function is expressed as: Where: • k determines the upper bound of yt; • parameters a and b determine the location and shape of the curve. The logistic curve reaches its maximum growth rate kβ=4 when yt ¼ k=2. The logistic curve is symmetric about its inflection point. 42
  • 44. The exponential function is expressed as: :______________________________________ Where: • ln yt is the natural logarithm of the number of existing subscribers at time t; • coefficient b determines the constant proportional change in the variable y. 4.2 Empirical data analysis In this section empirical data analysis using various statistical techniques is conducted. First of all correlation between number of Lithuanian mobile phone subscribers and economic variable will be analyzed (GDP, average income). This should give an answer to the question weather decision to become a mobile phone user is influenced by economical factors. Also correlation number of Lithuanian mobile phone subscribers and the number of fixed line subscribers will be employed, to answer the question weather the decision to become a mobile phone user is influenced by technological substitution factor. Secondly regression is employed also to test the relationship between number of Lithuanian mobile phone subscribers and mentioned independent variables (GDP, average income, number of fixed line subscribers). Additionally to the simple regression, multiple regression models are used to test to test the relationship between variously paired independent variables. Thirdly number of Lithuanian mobile phone subscribers is analyzed using time series method. Different functions for time series are employed and analysis is should provide an answer to the question which of which of the used function can describe the variation precisely. Also exponential function is analyzed as in the Botelho, Pinto (2004) research and results are compared. Data on the number of Lithuanian mobile phone subscribers for the research is available for the period 1996 – 2004, as 1996 was the first year when data about generation mobile communication was started to be collected in Lithuania. 43
  • 45. Table 4.1 Cumulative data of mobile phone and fixed line subscribers. Mobile Fixed line Time subscribers, subscribers, period thou. thou. 1996 51 992,6 1997 150,8 1048,2 1998 267,6 1109,8 1999 343,6 1144,6 2000 508,9 1180,1 2001 1018 1144,5 2002 1631,6 929,6 2003 2152,6 827,8 2004 3421,54 776 Source: Lithuanian Statistical Department, (http://www.std.lt) GDP data and average income is adjusted is adjusted according to 2000 price level. Table 4.2. Economical variables Average Time GDP, in income, period thou LTL LTL 1996 38821 618,2 1997 41541 778,1 1998 44565 929,8 1999 43810 987,4 2000 45526 970,8 2001 48429 982,3 2002 51704 1013,9 2003 56716 1072,6 2004 60511 1157,8 Source: Lithuanian Statistical Department, (http://www.std.lt) 44
  • 46. 4.2.1 Correlation analysis In Table 4.3 the results of strength of relationship between number of mobile phone subscribers and yearly GDP is demonstrated. We can see that Pearson correlation coefficient implies that positive correlation with very strong relationship exist between variable. Coefficient value 0,974 is very near to perfect correlations, meaning that the variables are precisely related. Also we can observe that this correlation is statistically significant, with probability value lower than 0,001. Table 4.3 Correlation. Number of mobile phone subscribers and GDP. Correlations Mobile_subscri GDP bers_thous Mobile_subscribers_thous Pearson Correlation 1 0,974 Sig. (2-tailed) 0,000 N 9 9 GDP Pearson Correlation 0,974 1 Sig. (2-tailed) 0,000 N 9 9 **. Correlation is significant at the 0.01 level (2-tailed). Scatter diagram of variable (Figure 4.1) also demonstrates that when one variable increases, another variable behaves in very predictable way: 45
  • 47. Figure 4.1. Scatter diagram for mobile phone subscribers and GDP In Table 4.4 we can see the results of relationship between number of mobile phone subscribers and average income. Pearson correlation coefficient value 0,773 demonstrates rather strong positive relations between variable. However we can clearly observe that relationship between the variables is statistically insignificant with probability value 0,015. Table 4.4 Correlation. Number of mobile phone subscribers and average income. Correlations Mobile_subscri Average_Incom bers_thous e Mobile_subscribers_thous Pearson Correlation 1 0,773 Sig. (2-tailed) 0,015 N 9 9 Average_Income Pearson Correlation 0,773 1 Sig. (2-tailed) 0,015 N 9 9 *. Correlation is significant at the 0.05 level (2-tailed). 46