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Published: May 21, 2003

 
 

Irrational Exuberance: How the Telecom Industry Went Astray

Demand Myths
The second variable commonly present in the development of an irrationally exuberant business plan is the overestimation of market potential. As Charles Kindleberger noted, “Investors tend to choose the wrong modeling tool, fail to take account of a critical piece of information, or go so far as to suppress information that does not conform to the business case implicitly adopted.”

In the telecommunications industry, we have found two primary mechanisms by which companies systematically overestimate demand, which we have labeled the “myth of unmet demand” and the “myth of 1 percent technological substitution.”

In the first myth, corporate investors assume that a new service or technology platform will meet important unsatisfied needs. Although that might be the case on rare occasions, those who fell prey to the myth of unmet demand during the wireless mania ignored the difference between primary and secondary demand for telecommunications services. In communications, primary demand is already largely met by existing technologies and services; new services may enable companies to capture a portion of that original demand, and even to stimulate some new demand, but users rarely have a completely unmet need. A classic case of primary and secondary demand can be illustrated by the interrelationship between pay phones, calling cards, and wireless telephony. A portion of the primary demand captured by wireless telephony was originally met by a combination of pay phones and calling cards; initial market projections for mobile telephony overestimated demand for wireless by neglecting the existence of these substitutes.

Demand overestimation also results from ignoring basic sociodemographic information — particularly regarding disposable income — to justify a telecommunications investment. For example, over the past 10 years, conventional wisdom established that telecommunications investment in emerging markets was naturally attractive because of the limited capability of monopolies to meet the demand gap. Although this was partly true, the fact was that the privatization of state monopolies, which generally occurred before deregulation (Colombia and South Korea are the exceptions), allowed those carriers to close the demand gap very effectively in their markets. New entrants anticipating a frenzy of unmet demand were left to compete for existing users.

New entrants also became excited about serving low-income segments of the population. But the barriers to this strategy are far steeper than many players realized. In Latin America, 70 percent of the population does not have access to telephone service; although this is a business opportunity, meeting it is a hard climb. Those who make up this population do not have the disposable income to purchase the service, and they will probably never become users unless they benefit from universal service policies.

The myth of 1 percent technological substitution, the other common cause of demand overestimation, refers to a statement that showed up in many business plans during the past several years, to the effect that a “mere 1 percent share” of the total telecom market would yield an adequate return on the investment. Such unexamined assertions trivialized the target and vastly understated the risks of telecom ventures. Worse, by defining the market as the aggregate demand for all telecommunications services, this rationale inaccurately assessed primary demand for a newly planned service.

Why did these myths — and other examples of investors’ demand overestimation — persist? One reason is the misuse of market-sizing indicators. For example, to justify entry into the data communications segment, business plan after business plan accepted without critical evaluation the projection that Internet traffic would double every month or two over an extended time horizon. Hindsight has shown that few investors extrapolated traffic correctly. They looked, for example, at traffic growth in the context of initial adoption stages, when the increase is naturally explosive, but routinely failed to take into account mitigating data, such as computer usage growth patterns. Had corporate investors done that, they would have concluded that achieving projections based on the extrapolation of growth rates characteristic of incubation periods was impossible.

 
 
 
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Resources

  1. Raul L. Katz, Maximilian Weise, and Daniel Yang, “The U.S. Wireless Industry: Consolidation Scenarios,” white paper, 2002; Click here.
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  14. Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises (Basic Books, 1978)
  15. Robert J. Shiller, Irrational Exuberance (Princeton University Press, 2000)
 
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