A new view of telecommunications economics

The Telecommunications Act of 1996 required that charges for interconnection, universal service and unbundled network elements should be based on cost, and directed the Federal Communications Commission to implement this legislation. The parties developed engineering process models to estimate forward-looking costs. Both the engineering economics and the cost model approaches were unsatisfactory. Neither handled uncertainty nor dynamics, or else did so in an awkward manner. The economic and financial literature has moved beyond these static concepts. This literature has methods to handle uncertainty and dynamics in a satisfactory manner. Moreover, it can link the ‘‘real’’ market with the financial market. This has immediate implications for both engineering economics and cost modelling methodologies. Engineering economics uses the tools of discounted cash flow (DCF) with little or no emphasis on how the ‘‘proper’ discount rate is obtained. The more sophisticated analysis may use a riskadjusted discount rate determined by the capital asset pricing (CAPM) model; however, some managers, intuitively, may raise the discount rate above this level to account for ‘‘risk’’. This lowers the cash flow values in later periods, distorts the results and gives incorrect conclusions. Certainty of the cash flow is assumed. Decision tree analysis (DTA) is used to address multiple possible outcomes. The DCF of the expected value of this tree is used for the evaluation. However, neither of these methods adequately deals with management’s flexibility. Real options, on the other hand, does have this capacity.