Real Options and the Costs of the Local Telecommunications Network*

by Nicholas Economides **

June 1999


The Telecommunications Act of 1996 invites entry in the local telecommunications networks whereby entrants will lease parts of the network ("unbundled network elements") from incumbents "at cost plus reasonable profit." A crucial question in the implementation of the Act is the appropriate measure of cost. This paper examines the economic principles on which the cost calculation should be based. I conclude that the appropriate measure of cost (maximizing allocative, productive, and dynamic efficiency) is forward-looking economic cost and not the historical, accounting, or embedded cost of the incumbentís network. In calculating costs, demand and supply uncertainty, as well as the asymmetric position of incumbents and entrants should be taken into account. Close examination of the issue of uncertainty in the local telecommunications network reveals that (i) for most unbundled network elements, there is little demand uncertainty; and (ii) that those elements that face significant uncertainty, do not have sunk value. Thus, the incumbent does not face higher expected cost by investing. Moreover, the rewards of the incumbent can be higher because buyers prefer to buy services from the owner of the network. Finally, strategic considerations in oligopolistic interaction are likely to dominate any uncertainty considerations and will increase the incentive of incumbents to invest.

Key words: telecommunications, regulation, cost, real options

JEL classification: L1, D4

* Forthcoming in The New Investment Theory of Real Options and its Implications for the Cost Models in Telecommunications, James Alleman and Eli Noam (eds.), Kluwer, 2000. Presented at the conference on "Costs of the Local Telecommunications Network," Columbia University, October 2, 1998

* Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, e-mail:, WWW:

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