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Published: May 21, 2003


Irrational Exuberance: How the Telecom Industry Went Astray

During each step of this process, the combination of conflicting interests, analytical biases, and irrational behavior can become a force that pushes the investment decision in a direction that is inconsistent with rational investor expectations. Herd behavior, premised on the belief that competitors are moving in a direction that might preempt profit maximization or market entry, exacerbates the irrationality, often resulting in a series of mistaken projections of demand and supply for the new service.

Consider the variables that can influence the analytical rigor of the business plan. We have identified four: the regulatory framework, overestimation of demand, overestimation of market share, and mistakes in entry strategy. (See Exhibit 1.) Not all variables appear simultaneously, but at least two of the four tend to emerge when a telecommunications business plan is under development.

Nobel Prize–winning economist Joseph Stiglitz, in his keynote presentation at the 2002 Columbia University conference “The New Telecommunications Industry and Financial Markets: From Utility to Volatility,” established that deregulation has been associated with speculative bubbles through time. And indeed, in the telecommunications industry, the regulatory framework fashioned by governments to promote competition is the dominant variable in driving irrational exuberance, having prompted in many countries a flurry of new participants in search of business opportunities.

Governments face conflicting objectives when authorizing players to compete in a market. A capital-intensive industry such as telecommunications exhibits extremely strong economies of scale, which argues for a limited number of competitors doing business, with strong regulatory oversight. Accordingly, a government hoping to create a vibrant industry should naturally limit entry to a few players.

However, governments, especially in emerging countries, are also motivated by revenue needs. Particularly in the wireless industry, the larger the number of spectrum positions available for licensing, the better it is for the national treasury, regardless of the ultimate sustainability of individual players. Because a multiplicity of players also leads to rapid job creation and an influx of foreign investment, governments will tend to allow operators unlimited entry, whatever the long-term impact. In many cases, governments have rationalized the desirability of this open market by promoting the consumer benefits that result from competition.

In addition to the economic incentive, we have found that governments will adopt policies in direct imitation of other countries’ regulatory frameworks, without regard to their suitability in a different environment. Geographical propinquity — “copying your neighbor” — and common membership in international organizations contribute to such reckless policy diffusion. Developing countries also commonly copy deregulation models adopted by industrialized nations before the effectiveness of those models can be properly assessed.

Whereas governments’ short-term economic and political needs bias them in favor of unlimited entry, one might expect corporate investors to operate more circumspectly. Yet, typically, companies systematically follow the lead of governments and pile into newly opened markets, despite limitations that should be obvious. In Chile, for example, 21 investors applied for a long-distance license to operate in a market valued at only $500 million. By not restricting entry on the basis of natural monopoly or minimum efficient market-share assumptions, government serves as a critical enabler of irrational exuberance.

In the case of the hotly debated 2001 U.S. wireless auctions, irrational bidding behavior was probably directly attributable to the regulatory process; regulators, after all, designed the auction. Because the public policy goal was to encourage more entrepreneurial participants, up-front payments were reduced and payment periods extended. New entrants joined traditional players in the auction. With limited capital at risk in the case of loss or default, the increased number of players with varying risk profiles caused bids to rise significantly above previously recorded levels.

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