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Cost-Benefit Analysis and Review of Regulatory Arrangements for the National Broadband Network

Cost-Benefit Analysis of Public Investment in High

Speed Broadband Network Infrastructure:

An Analytical Framework

Dr Alex RobsonDirector, Economic Policy Analysis Program

Department of Accounting, Finance and Economics

Griffith University

May 2014

Contents

Executive Summary 5

Background and Context...........................................................................................................................5The Relevant Baseline or Reference Scenario(s)........................................................................................8

Benefits...................................................................................................................................................13

Costs........................................................................................................................................................16

Non-Quantifiable Benefits and Costs.......................................................................................................18

Overall CBA Strategy................................................................................................................................19

1. Introduction 21

1.1. Background and Context........................................................................................................21

1.2. What is Cost-Benefit Analysis? And Why Conduct One?.......................................................22

1.3. Statement of the Economic Problem.....................................................................................24

1.4. Structure of the Paper...........................................................................................................25

1.5. Key Analytical Issues..............................................................................................................26

2. What Should Project Outcomes be Measured Against?

Baseline/Reference Scenario(s) 29

3. Benefits 35

3.1. The Indirect Demand for Faster Broadband Speeds..............................................................36

3.2. Pure Time Savings..................................................................................................................39

3.3. Reduced Transaction Costs....................................................................................................41

3.4. Travel Time Savings................................................................................................................42

3.5. Productivity Improvements...................................................................................................42

3.6. Estimation of Private Willingness to Pay................................................................................43

3.6.1. Hedonic Regression Using Market Data.................................................................................43

3.6.2. Discrete Choice Estimation Using Survey Data.......................................................................44

3.7. Benefits Over Time................................................................................................................45

3.7.1. Product/Innovation Diffusion Models....................................................................................46

3.8. Network Effects.....................................................................................................................49

3.8.1. Direct Network Externalities..................................................................................................49

3.8.2. Indirect Network Externalities...............................................................................................52

3.9. Fiscal Effects...........................................................................................................................52

3.10. Wider Economic Benefits (WEBs)..........................................................................................56

3.10.1. Economies of Agglomeration.................................................................................................56

3.10.2. Labour Supply and Taxation...................................................................................................58

CBA Analytical Framework of 95

3.10.3. Competition/Market Power Effects.......................................................................................59

4. Costs 60

4.1. Direct Costs............................................................................................................................60

4.2. The Social Discount Rate........................................................................................................61

4.3. The Timing of Investment and Option Values........................................................................64

4.3.1. Dynamically Efficient Investment...........................................................................................64

4.3.2. Option Values........................................................................................................................64

4.4. Taxation.................................................................................................................................66

4.4.1. General Considerations..........................................................................................................66

4.4.2. The Marginal Cost of Public Funds.........................................................................................67

4.4.3. Taxation and Uniform National Wholesale Access Pricing.....................................................69

4.5. Non-Quantifiable Benefits and Costs.....................................................................................71

5. Conclusion and Recommendation for Overall CBA Strategy 72

6. References 74

Appendix 1. The Indirect Demand for Faster Broadband Speeds 78

Appendix 2. The Simple Welfare Economics of the Gains from Productivity Improvements

80

Appendix 3. Welfare Analysis in Discrete Choice Models 81

Appendix 4. The Dynamic Efficiency of S-Shaped Product Diffusion Curves 83

Appendix 5. A Simple Model of Network Effects 86

Appendix 6. The Dynamic Efficiency of Investment 90

Appendix 7. The Costs of Taxation 92


Figures

Figure 1.1: Network Access Versus Take-up and Usage........................................................................27

Figure 3.1: Illustration of the Effect of a Marginal Increase in Broadband Speeds on Welfare and Demand for Other Products................................................................................................37

Figure 3.2: Illustration of the Effect of a Marginal Increase in Broadband Speeds on Welfare and Demand for Other Products: The Case of a New Good.......................................................38

Figure 3.3: Faster Broadband Speeds in a Simple Time-Use Model......................................................40

Figure 3.4: The Impact of Faster Broadband Speeds on Consumer Welfare.........................................41

Figure 3.5: Example of a Logistic Product Diffusion Curve (=0.3, =2)................................................46

Figure 3.6: Change in Take-up Rates Implied by the Logistic Product Diffusion Curve (=0.3, =2)........................................................................................................................47

Figure 3.7: The Effects of Lower Unit Costs on Optimal Spending and Provision of a Publicly Provided Good...................................................................................................................................54

Figure 3.8: The Effects of Lower Unit Costs on Optimal Spending and Provision of a Publicly Provided Good – Taxes are Distortionary...........................................................................................55

Figure 4.1: The Present Value of $1 Received at Different Points in the Future, for Different Discount Rates...................................................................................................................................62

Figure 4.2: Welfare Effects of a Change in Demand When an Existing Good is Taxed..........................67

Figure 4.3: The Marginal Cost of Funds and the Optimal Provision of a Publicly Provided Good..........68

Figure 4.4: Cross-Subsidies as an Implicit Tax-Subsidy Scheme............................................................71

TablesTable 2.1: Two-Way Classification of Policy Alternatives and Scenarios......................................................34


Executive SummaryThis paper provides an analytical framework for the conduct of the panel’s cost-benefit

analysis of the national broadband network. Its aim is to set out the issues,

considerations and calculations that economic and cost-benefit analysis theory tells us

should be thought about in a cost-benefit analysis of this type. As such, the paper is

primarily theoretical and delves into the full range of items about which a cost-benefit

analysis practitioner will want to think, including, in some cases, options for estimating

or assessing costs and benefits.

The panel has done this to ensure that its cost-benefit analysis has a sound theoretical

basis and that it is transparent about the analytical framework it is using.

In doing this, the panel acknowledges that theory is just part of the process. There is

significant work in the next steps of the cost-benefit analysis applying the analytical

framework to produce an actual cost benefit analysis. This work involves taking the

theory and applying it to the practical world of high speed broadband in Australia and

the tools, techniques and data available to make estimates. Part of this work will

determine practical ways of measuring costs and benefits and the significance or

materiality of various theoretical issues (which may determine how they are treated in

the estimates or even if they are excluded). This work is underway and will be in the

final cost-benefit analysis.

Background and Context

In December 2013 the Minister for Communications announced a panel to conduct an

independent cost-benefit analysis (CBA) of broadband policy and review the regulatory

arrangements for the National Broadband Network.

The panel’s terms of reference and further background information are available on the

Department of Communications’ website.1

1 http://www.communications.gov.au/broadband/national_broadband_network/cost-benefit_analysis_and_review_of_regulation


http://www.communications.gov.au/broadband/national_broadband_network/cost-benefit_analysis_and_review_of_regulationhttp:/www.communications.gov.au/broadband/national_broadband_network/cost-benefit_analysis_and_review_of_regulation

The aim of this paper, commissioned by the panel (through the Department of

Communications), is to develop an analytical framework which will assist the panel in its

development of this CBA.

The basic purpose of any CBA is to inform government decision making by systematically

assessing the extent to which the social benefits of pursuing a particular policy or

project exceed the social opportunity costs, given economic and other constraints. CBAs

focus on economic efficiency, which is broadly defined as the dollar value of the gains,

less the dollar value of losses for those individuals and businesses directly and indirectly

affected by the policy change. In a standard CBA, benefits and costs are summed across

all individuals in the community. Questions regarding the overall dollar value of net

gains are separated from issues regarding the equity of end-results and the distribution

of those net gains.

The use of dollar values means that policies can be compared with one another in a

consistent fashion, which facilitates a ranking of policy options against each other. A

CBA also considers non-financial effects or broader social and environmental effects and

the costs and benefits of goods and services not exchanged on markets. A thorough

CBA should, to the greatest practicable extent, take into account and estimate the dollar

value of all of the effects of a particular policy change on the community (economic,

social and environmental) and should include both market and non-market values

where relevant. All non-quantifiable benefits and costs – either because of their

inherent nature or because of a lack of suitable data – must also be fully explored and

the findings presented alongside the valued effects.

The steps involved in a typical CBA are:

1. Collect existing information and data.

2. Establish the policy objectives. What is the economic problem that policy is

directed at addressing?

3. Determine a baseline or reference scenario.

4. Establish policy options.


5. Identify costs and benefits and estimate their value or qualitatively assess those

that are non-quantifiable.

6. Apply an appropriate discount rate to future cash flows to calculate net present

value, rank policy options (taking into account both the quantitative and

qualitative work) and suggest the most beneficial options.

7. Conduct a sensitivity analysis.

The ultimate purpose of a CBA is to inform policy decisions. By identifying and

measuring all costs and benefits, a CBA can help policy makers make decisions that

maximise net benefits to the community.

One of the most important first steps in a CBA is to identify the economic problem that

policy is meant to address. In the present context, the first step is to ask: what objective

is to be achieved by undertaking public investment in high speed broadband (HSBB)

network infrastructure? The main features of HSBB networks are their coverage (i.e.

the set of consumers that are able to access the network) and the speed available to

those who are connected (this should be taken to be the download and upload speeds

as actually experienced, rather than a hypothetical maximum speed). Given these key

features, the basic policy question underpinning any CBA of public investment in HSBB

network infrastructure could be described as follows:

What are the characteristics – in terms of the network’s key features – of the socially

optimal (i.e. efficient) network rollout, given current community preferences,

technology, costs, fiscal constraints and regulatory settings, and the likely evolution of

these ‘parameters’ over time?

Although the primary purpose of a CBA is not to solve this complex, constrained,

optimisation problem, in practice assessing various policy options may involve either

implicitly or explicitly benchmarking the consequences of various policy options

(including the alternative of “no policy change”) against some socially optimal set of

arrangements (i.e. arrangements that maximise net benefits). Hence, insofar as a CBA is

intended to inform the discussion of broadband policy more generally, identifying the

broad characteristics (in terms of coverage and speed) of the efficient rollout path

would be a valuable exercise.


The stated purpose of the Government’s independent CBA and review of regulation is to

“analyse the economic and social costs and benefits (including both direct and indirect

effects) arising from the availability of broadband of differing properties via various

technologies, and to make recommendations on the role of Government support and a

number of other longer-term industry matters”. Given the range of new and highly

complex issues that are likely to be involved in a CBA of this type, there are significant

risks in proceeding without a sound analytical framework. This paper develops such a

framework from a theoretical perspective. The purpose is to provide conceptual

guidance for the CBA, identifying and exploring the main sources of the potential

economic impacts of policies that are designed to achieve greater network coverage and

access to faster broadband speeds, as well as providing broad guidance on how to

estimate the magnitude of these impacts. Using such a framework can help to avoid

double counting of benefits and costs in a CBA. It can also, where appropriate, provide

guidance as to the likely economic importance and sign and size of particular impacts.

This paper focuses on three key areas:

The Relevant Baseline or Reference Scenario(s);

Benefits; and

Costs.

The Relevant Baseline or Reference Scenario(s)

As discussed above, the central question in undertaking a CBA of various broadband

policy options is whether the incremental social benefits of an increase in network

coverage and speeds associated with a particular policy are likely to outweigh the

incremental social costs of that particular option. The question is: incremental

compared to what? Using the language of the basic policy question set out above, what

is required is a set of inputs or parameter assumptions that can be fed into the

optimisation problem. In practice this means constructing a reasonable, credible

baseline or reference scenario in which some or all of the social benefits from a

particular policy may be realised over time (but not necessarily at the same time) even

without major policy changes. In this context, it is important to note that, over the last


decade, neither the availability of broadband nor adoption rates have remained

stagnant in Australia; nor would they be expected to do so in the future.

It is crucial for any CBA to ascertain, as a first step, the extent to which existing

applications, services, products and devices – as well as those likely to be developed,

made available and taken up over the medium term – are able to achieve an acceptable

level of functionality at speeds that are either already available or likely to become

available using existing infrastructure and technology, or using infrastructure that is

likely to be constructed and technological changes that are likely to occur over the

medium term, in the absence of major policy changes.

On the demand side these are essentially technological questions, which require an

examination of peak transmission requirements of various services and combinations of

services (such as high quality video conferencing, Internet Protocol television (IPTV),

streamed video, video and software downloads and general web usage), the extent to

which these transmission requirements are likely to change over the medium term due

to technological innovation (e.g. in video compression) or moves towards “content-rich”

environments, and the extent to which increases in download and upload speeds are

likely to yield economically noticeable changes in existing overall service quality.2

Similarly, on the supply side answering these questions will require an examination and

assessment of existing infrastructure, including the download and upload speeds that

can be experienced by customers using copper lines connected to ADSL2+ enabled

exchanges, and the coverage and capability of existing hybrid fibre coaxial (HFC)

networks, fixed wireless networks, and 3G and 4G mobile networks. It will also require

an assessment of likely future supply side developments (e.g. developments in wireless

and satellite technology, increased use of VDSL) that may occur in the absence of major

policy changes.3

2 Relevant here is Robert Kenny and Tom Broughton’s Domestic Demand for Bandwidth, an approach to forecasting requirements for period 2013 to 2023, see <http://www.commcham.com/storage/publications/BSG-Domestic-demand-for-bandwidth.pdf>.

3 Much of the work for such an assessment has recently been carried out by the Australian Government; see the Department of Communications’ 2013 report, Broadband Availability and Quality.


It is impossible to precisely determine the dynamically efficient path4 of high speed

broadband infrastructure investment in the Australian context (taking into account

demand and supply side uncertainty, irreversibility of investment, and the potentially

large number of option values that are embedded in investment decisions). However, it

would be highly desirable for a CBA to determine the most important economic features

of such a dynamically efficient path – including the economic trade-offs involved, and

the incentives on the demand and supply side of the relevant markets. Given the results

of such an analysis, it would also be desirable to examine and determine the extent to

which market outcomes – supported by appropriate regulation – will deliver the

features that characterise the dynamically efficient investment path. Such features

include the timing of aggregate investment, the extent of population coverage over

time, the extent of competition, pricing arrangements, capacity choice and congestion,

download and upload speeds, as well as other characteristics.

Addressing these issues necessitates the construction of a credible reference or baseline

scenario, which in turn involves careful consideration. In the language of the basic

policy question set out earlier, varying the reference scenario involves varying the

parameters of the optimisation problem. Given that there is a significant amount of

uncertainty regarding the precise evolution of technology and the development of

consumer applications and devices over the medium term, it would be preferable to use

a range of parameter values. In other words, the CBA should develop a suite of different

reference scenarios, each of which can ultimately be used as an input into sensitivity

analysis.

4 The dynamically efficient path is the one that maximises the expected net present value of benefits minus costs.


Factors that should be addressed in the construction of these scenarios include:

The current state of Australia’s broadband market, and the economic drivers of

the evolution of the market to date.

The evolution of private sector telecommunications infrastructure investment in

Australia, and the incentives that competition and market forces have provided

for such investment.

The role that regulation has played in influencing the evolution of market

outcomes, including its influence on incentives for investment, consumer prices,

capacity, network coverage and speed.

Given supply and demand side uncertainties, this paper is deliberately non-prescriptive

regarding the specific choice of baseline scenarios. However, at the minimum, the CBA

could examine three broad classes of parameter assumptions or reference scenarios:

Pessimistic scenarios in which private investment in – and take-up of – faster

speeds are inefficiently delayed to a significant extent, or where the breadth of

coverage is significantly inefficiently narrow. In constructing this scenario it is

crucial to carefully identify the reasons that may drive such an outcome – that is,

the market or regulatory failures that are likely lead to inefficient delay.

Intermediate reference scenarios, in which market outcomes are, in theory,

likely to be dynamically efficient. In developing these scenarios it would be

important to explore the reasons why market failures are likely to be minimal,

and the policy and regulatory settings that are likely to lead to such an outcome.

Optimistic or over investment scenarios, in which private investment in network

coverage and speed – as well as take-up rates – develops more rapidly than the

dynamically efficient path, or where network coverage is extended to areas

where it is inefficient to do so (i.e. where costs exceed benefits). Again, in

constructing such as scenario it will be important to carefully identify the market

or regulatory failures that may lead to inefficient overinvestment.


Different features from a subset of these scenarios could be chosen and combined with

each other to form hybrid reference scenarios. The extent to which such scenario-

building is employed is ultimately a matter of judgement for the CBA analyst.

The quantitative results of the implicit optimisation exercise undertaken in a CBA will be

a function of the assumed parameters (i.e. the reference scenario). This is a strength of

a CBA rather than a weakness, as results can be mapped clearly and transparently back

to the assumptions made. On the other hand, it is possible that the qualitative results of

a CBA – for example, whether a particular project yields positive incremental social net

benefits – may not vary greatly with the assumed reference scenario. Importantly, if

there is a great deal of uncertainty about modelling parameters or assumptions and the

qualitative features of the CBA vary widely with these assumptions, this suggests there

is a great deal of risk associated with the project. This is likely to be useful information

for decision makers.

Once these reference or baseline scenarios have been constructed, they can then be

compared against the likely outcomes under various policy scenarios. In comparing

reference scenarios against policy scenarios, it is important that the CBA examines and

realistically assesses policy failures and implementation failures. That is, the extent to

which policies address the sources of market or regulatory failure that are assumed to

drive the evolution of outcomes in the reference scenario, and the extent to which

stated policies are likely to be implemented in such a way as to achieve their stated

goals. Policy changes that are subject to these kinds of failures are less likely to yield

incremental net benefits relative to the reference scenario, and under some

circumstances may actually yield negative incremental benefits even assuming a

relatively pessimistic baseline scenario.


Benefits

Sources of Benefits

Conceptually, faster broadband speeds may provide a range of benefits to consumers

and producers. The paper identifies these as:

Increase in Benefits from Using Existing Products, and the Benefits from the

Ability to Use New Products.

Pure Time Savings.

Reduced Transaction Costs.

Travel Time Savings.

Productivity Improvements.

Whilst conceptually these are separate effects, since the benefits accrue directly to

individuals or firms, in many (but not all) cases they will be captured in estimates of

consumers’ and producers’ direct willingness to pay for faster broadband speeds.

Because there may be a range of benefits, one of the risks in undertaking any CBA is that

it may either fail to rigorously specify the conceptual foundation of benefits; double

count benefits; or count costs as benefits. Another risk is adopting narrow definitions of

particular effects because they make valuation easier.

Although levels of willingness to pay for faster speeds are important, a key consideration

for ascertaining the characteristics of the dynamically efficient network investment path

is the likely overall shape of willingness-to-pay curves (as a function of download speed),

which provide an indication of how willingness to pay may change over time. Even if the

quantum of future benefits is difficult to precisely determine, it would be useful to

obtain qualitative information regarding the likely evolution of future incremental

benefits.

There are a number of good economic reasons to expect that willingness-to-pay curves

for faster broadband speeds are concave – that is, other things being equal, consumer

marginal willingness to pay for faster speeds is likely to be positive, but decreasing.


First, existing economic studies suggest that there are diminishing marginal benefits to

faster speeds.5 Second, since overall service quality will depend on the data

requirements for each broadband activity, and whether they are undertaken one at a

time or together, moving from 25 Mbit/s to 50Mbit/s for example may make little

difference to overall service quality if the customer’s demand for existing applications,

services, products and devices can be satisfied by a peak requirement of less than 25

Mbit/s. On other hand, applications that have yet to be invented or widely adopted

could require faster individual speeds to achieve a minimal level of functionality, and so

a move from 25 Mbit/s to 50Mbit/s would mean a great deal for service quality if the

introduction of these products into the broadband activity mix required a peak

requirement greater than 25 Mbit/s. For these kinds of combinations of services, it will

be important for a CBA to determine the range of points at which further increases in

speed will be unlikely to significantly improve service quality, and to subject this to

sensitivity analysis. Third, once a domestic broadband network is operating at

reasonably high speeds, the links between the first point of domestic traffic aggregation

and the global Internet may act as one of the main constraints on further improvements

in speed. Fourth, as discussed further in the paper, for some kinds of benefits, basic

economic principles suggest that there will be diminishing marginal returns.

On the demand side, it is important to note that the demand for faster broadband

speeds is a derived demand. The goods that consumers value directly are services,

applications, products and devices. Access to faster broadband speeds is one of a

number of product characteristics or attributes that can enhance the value that

consumers attach to these end-use products. Faster speeds can be a substitute or

complement for other product attributes. Willingness to pay for faster speeds stems

from the ability of those faster speeds to enhance the marginal value from consuming

existing goods, or to increase demand for new applications, products, services and

devices.

5 For example, Dutz et al (2009) estimate the net consumer benefits from home broadband in the United States are of the order of US$32 billion per year, whilst the benefits of an increase in broadband speed from 100 times the typical historical speed of dial-up service to 1,000 times dial-up, are of the order of US$6 billion per year for existing home broadband users. They also document an “experience effect” – consumers who currently enjoy fast speeds value faster speeds over 40 percent more than households who currently have dial-up connections.


This has a number of important implications that are explored in the paper. For

example, one simple implication is that even if faster speeds increase the demand for

yet-to-be-invented applications, products, services and devices, any increase in marginal

value must be compared against the prices at which those innovations are actually

made available, which in turn is related to their production cost.

Estimation of Private Benefits

The paper briefly discusses two major methods that have been used to estimate private

willingness to pay in other contexts, using market based data or consumer survey

responses. These are standard approaches in the empirical literature and there are

many examples which can be used as a guide for a CBA of faster broadband speeds.

Benefits Over Time

The intertemporal pattern of demand for applications, products and services will drive

the evolution and growth of aggregate benefits of faster speeds over time. Since any

public infrastructure project will take many years to construct and will likely have very

high upfront costs, it becomes crucial to specify exactly when future benefits are likely

to accrue in both the project and baseline scenarios. Therefore, credible projections of

likely take-up rates are required, and these should be subjected to detailed sensitivity

analysis. The paper briefly discusses some standard approaches that are used in the

product diffusion literature to forecast take-up/adoption rates. The paper notes that if

these approaches are used, a CBA should ideally ensure that take-up projections are

consistent with assumptions regarding the evolution of consumer benefits and other

market variables over time.

Other Possible Sources of Social Benefits

A distinguishing feature of a CBA is that it considers external costs and benefits, as well

as private costs and benefits. This paper discusses the possible sources of benefits that

may not be reflected in measures of private willingness to pay. These include:

Network Effects: These are positive demand side externalities that reflect the

notion that consumers may value accessing a network if it has more users. A key


question here is the extent to which network effects are impacted by faster

connection speeds.

Fiscal Effects: These are effects associated with changes in tax revenue and

spending, as well as the quality of provision of government services. The analysis

in this paper suggests that projected reductions in government spending are

likely a poor proxy for measuring the benefits that can be attributed to public

sector activity. A preferable approach would be to directly estimate the changes

in social benefits and costs as a result of public sector costs falling, or the

benefits from changes in the quality or characteristics of publicly provided goods

and services. In assessing the net benefits of new government services that may

be introduced, or changes in quality, it is important to net out the additional

costs that may be incurred in securing these benefits – particularly in e-health

and online education.

Wider Economic Benefits: These are positive external benefits associated with

agglomeration, changes in market structure, and labour supply. This paper

considers these effects, and concludes that some of these effects could be

ambiguous in the case of HSBB (that is, they involve costs and well as benefits).

These effects should therefore be treated with particular care.

Costs

For the purposes of a CBA of HSBB network infrastructure projects, estimating the

quantifiable social costs of any project will require three important components: direct

costs; the cost of capital (the social discount rate); and the opportunity costs of taxation

needed to fund the project. Pricing arrangements (such as uniform pricing, which may

involve a scheme of implicit taxes and subsidies) may also impose social costs that

should ideally be captured in a CBA.

Regarding direct costs, ideally a “bottom-up” cost modelling approach should be

employed for this purpose, using engineering and construction data and assumptions

regarding exchange areas, services, lines, contention ratios and so on. This task is likely

to require highly specialised technical knowledge regarding the physical engineering and

construction requirements of different project scenarios.


Different investment paths result in different present values of costs. For the purposes

of a CBA of HSBB networks, the investment paths of some infrastructure projects will

more closely resemble the dynamically efficient path than others. The costs of

inefficiently timed investment should ideally be accounted for in a CBA. Similar

considerations apply to option values. Typically, investment in HSBB networks is largely

irreversible, with uncertain costs and benefits. This means that delaying investment can

be privately and socially valuable. That is, construction of a HSBB network involves

purchasing and exercising a series of embedded real options. These options have value,

and this value should ideally be accounted for in any CBA.

Since a national HSBB network will take many years to construct and will have high

upfront costs, the choice of discount rate – which is used to compare streams of costs

and benefits over time – is crucial. Social risk is a key issue – there is considerable

uncertainty around both benefits and costs, and along multiple dimensions

(geographical/spatial, intertemporal etc.). This paper advocates the use of a market

based approach to choosing a discount rate, whilst acknowledging that there is little

consensus among economists as to what the “correct” choice of the discount rate

should be. A range of rates should therefore be used and subjected to sensitivity

analysis. The discount rate can be estimated using standard techniques, by calculating a

project’s weighted average cost of capital (WACC) using, for example, the capital asset

pricing model (CAPM) to determine the cost of equity.

In the present case, given uncertainty around take-up and revenue growth, government

investment is likely to have a high degree of systematic or non-diversifiable risk. It is

therefore appropriate for a significant risk premium (determined by an appropriately

chosen asset beta) to be added to the risk free rate.

On the costs of taxation, a basic principle of welfare economics is that the direct

resource costs of government spending should be grossed up by the marginal cost of

public funds (MCF) – that is, the costs of taxation – to determine the full social cost of

the project, which is the reduction in private surplus that occurs when the project goes

ahead. The Department of Finance’s Handbook of Cost-Benefit Analysis6 states that:

6 http://www.finance.gov.au/publications/finance-circulars/2006/docs/Handbook_of_CB_analysis.pdf


http://www.finance.gov.au/publications/finance-circulars/2006/docs/Handbook_of_CB_analysis.pdf

“The excess burden of taxation means the supply cost of public investment or services

are greater than the actual amount of funds used. Consequently, it is appropriate to

make an upward adjustment to financial costs in cost benefit analysis to ensure the

calculated net present value is unbiased. This is, however, only where there is a

significant net cost to the budget. It excludes cases where costs are fully recovered (such

as where there is a user charge) or the resources are already committed (which is

effectively so for cost-effectiveness analysis and lease-purchase analysis).”

Ignoring the MCF can have deleterious welfare consequences, and should be included in

any CBA where relevant.

A final important aspect of taxation that should be taken into account in a CBA is the

implicit tax and subsidy arrangement that uniform national wholesale access pricing

may entail. Imposing a uniform price means that downstream providers (and final retail

consumers) in low cost areas will effectively pay a tax, the revenue from which is used to

subsidise consumers in high cost areas. The social costs of such an arrangement should

be estimated where relevant.

Non-Quantifiable Benefits and Costs

As discussed above, ideally a CBA should place dollar values on all sources of costs and

benefits. However, there may be benefits and costs which are difficult to estimate

accurately, or which are simply non-quantifiable. For example, consumers and

producers may (due to, for example, a lack of information) systematically underestimate

(or overestimate) the likely impact that faster broadband speeds may have on future

innovations and the value of new applications, services and products (including, for

example, e-health and e-education applications). If these systematic biases are present

across a sufficient number of consumers and producers, then estimates of private

willingness to pay, which rely on information provided by these groups, may not

correctly and/or fully reflect relevant benefits. Other benefits may be difficult or

impossible to quantify, such as the benefit from being able to access the “knowledge

commons” of the global internet or, more relevant for policy, the effects of faster

speeds on these benefits. Similarly, there may be significant non-quantifiable social

costs associated with broader network coverage and faster speeds, including issues


related to privacy, data security, national defence and security, intellectual property

protection, net neutrality, cyber-crime and freedom of speech. These are clearly

important policy issues in their own right, and the extent to which they are affected by

various investment options deserves to be discussed and explored qualitatively in a CBA.

Overall CBA Strategy

Undertaking a comprehensive CBA is a challenging exercise. In practice a range of

theoretical assumptions and empirical compromises will need to be made. The key to

undertaking a robust CBA is to test how sensitive these are to changes in these

assumptions and compromises, to clearly demonstrate to decision makers how they

affect the CBA’s final results.

Given that the ultimate purpose of a CBA is to inform policy decisions, the most

straightforward way to proceed would be to begin with a (relatively) simple partial

equilibrium analysis of the effects of various policy options on network coverage, speed,

and incremental net benefits. Under this approach, the analysis would begin with the

simplest adequate model: social benefits would be assumed to be fully reflected in

private willingness to pay, and estimates of consumer valuation could be compared with

direct project costs. Factors such as externalities and other effects (which are discussed

further below) could be temporarily put to one side.

Once a partial equilibrium analysis is completed, some of the more conceptually difficult

issues explored in this paper could be dealt with. In the first instance, these factors

could be examined qualitatively, by exploring the extent to which a more complicated,

general equilibrium analysis would increase the economic value of various policy

options, and whether such effects are likely to vary greatly across options. For example,

it may be the case that the presence of demand side network externalities would

increase the net benefits of all policies by a similar magnitude, leaving unchanged the

overall ranking of policies that emerged from a simple partial equilibrium analysis.

Alternatively, if a simple partial equilibrium analysis suggests that the net benefits of

certain policies are likely to be negative, a qualitative analysis could be used to show

how positive the benefits from other sources would need to be to reverse the results of

the simpler analysis.


1. Introduction

1.1. Background and Context

In April 2009 the Australian Government announced the establishment of a new

company (the majority government-owned NBN Co) to build and operate the National

Broadband Network (NBN). The policy objective was to invest up to $43 billion over 8

years to connect 90 percent of Australian premises to broadband services with speeds

up to 100 megabits per second and to connect all other premises in Australia with next

generation wireless and satellite technologies that will deliver broadband speeds of 12

megabits per second.7

In December 2013 the Minister for Communications announced a panel to conduct an

independent cost benefit analysis (CBA) of broadband policy and review the regulatory

arrangements for the National Broadband Network. This followed a change of

government in September 2013.

The Terms of Reference for the panel8 state that:

“The purpose of the independent cost-benefit analysis and review of regulation is to

analyse the economic and social costs and benefits (including both direct and indirect

effects) arising from the availability of broadband of differing properties via various

technologies, and to make recommendations on the role of Government support and a

number of other longer-term industry matters.”

In particular, the review is to examine, among other things, the following questions:

“1. What is the direct and indirect value, in economic and social terms, of increased

broadband speeds, and to what extent should broadband be supported by the

government?

7 Prime Minister’s Media Release, 7 April 2009. <http://pmtranscripts.dpmc.gov.au/browse.php?did=16491 >.

8 <http://www.communications.gov.au/__data/assets/pdf_file/0019/207046/NBN_Panel_of_Experts_-_Terms_of_Reference.pdf >.


http://www.communications.gov.au/__data/assets/pdf_file/0019/207046/NBN_Panel_of_Experts_-_Terms_of_Reference.pdf

http://www.communications.gov.au/__data/assets/pdf_file/0019/207046/NBN_Panel_of_Experts_-_Terms_of_Reference.pdf

http://pmtranscripts.dpmc.gov.au/browse.php?did=16491

http://pmtranscripts.dpmc.gov.au/browse.php?did=16491

a. This should consider the economic and social benefits of bringing forward

improvements in broadband speed and the respective benefits of alternative /

potential technologies.

b. It should also consider the extent to which market pricing mechanisms

can capture the value of benefits (including benefits to Australian governments).”

Given the range of new and highly complex issues likely to be involved in such a CBA,

the panel decided to first develop a sound analytical framework. The aim of this paper,

commissioned by the panel (through the Department of Communications), is to provide

that framework. It provides conceptual guidance for the CBA, identifying and exploring

the main sources of the potential economic impacts of policies that are designed to

achieve greater network coverage and access to faster broadband speeds, as well as

providing broad guidance on how to estimate these impacts and avoid double counting

of benefits and costs.

1.2. What is Cost-Benefit Analysis? And Why Conduct One?

The basic purpose of any CBA is to inform policy by systematically assessing the extent

to which the social benefits of pursuing a particular government policy or project exceed

the social opportunity costs, given economic and other constraints. A CBA focuses on

the dynamic efficiency effects of a policy: the present value, measured in dollars, of the

gains that accrue over time, less the present value of losses for those directly and

indirectly affected by the policy change. The use of dollar values is a convenient

analytical tool and measurement device that has a number of distinct advantages

relative to other approaches [such as multi-criteria analysis (MCA), for example].9 In

particular, the use of dollar values means that policies can be compared with one

another in a consistent fashion, which facilitates a ranking of policy options against one

another.

The use of dollar values does not mean that a CBA ignores non-financial or broader

social and environmental effects; nor does a CBA ignore the costs and benefits of goods

and services that are not exchanged on markets. It should, to the greatest practicable

extent, take into account and estimate the dollar value of all of the effects of a particular

9 The advantages of CBA relative to MCA are examined by Dobes and Bennett (2009) and Ergas (2009).


policy change on the community (economic, social and environmental), and should

include both market and non-market values where the latter are relevant. All non-

quantifiable benefits and costs – either because of their inherent nature or because of a

lack of suitable data – must also be fully explored and the findings presented alongside

the valued effects.

In a standard CBA, benefits and costs are summed across all individuals in the

community. Questions regarding the overall dollar value of net gains are separated

from issues regarding end-results equity and the distribution of those net gains. Ideally

the latter issues should be dealt with in a separate policy analysis, so that assumptions

about distributional effects – and the nature of any trade-offs between equity and

efficiency – are explicit and are made transparent to both policy makers and the wider

community.

Generally speaking, the steps involved in a typical CBA are:

1. Collect existing information and data.

2. Establish the policy objectives: What is the economic problem that policy is being

asked to address?

3. Determine a baseline or reference scenario.

4. Establish policy options.

5. Identify costs and benefits and estimate their value or qualitatively assess those

that are non-quantifiable.

6. Apply an appropriate discount rate to future cash flows to calculate net present

value, rank policy options (taking into account both the quantitative and

qualitative work) and suggest the most beneficial options.

7. Conduct sensitivity analysis.

By identifying and measuring all costs and benefits, a CBA can help decision makers

maximise net benefits to society. Robust assessments of the costs and benefits of

government projects can improve the probability of sound policy decisions (and reduce

the probability of costly policy errors), and increase the chances that taxpayer-funded

projects that go ahead will produce net benefits for the community.


In the context of government infrastructure projects, there are at least two possible

errors that can be made:

Type I error: an economically beneficial project is rejected because it is

incorrectly assessed as creating a net welfare loss.

Type II error: an economically wasteful project is approved because it is

incorrectly assessed as creating a net welfare gain.

Rigorous CBA can reduce the probability of both types of errors.10

1.3. Statement of the Economic Problem

As discussed above, one the most important steps in a CBA is to identify the economic

problem to be addressed and the objective that policy is attempting to achieve. The key

features of HSBB networks are coverage (i.e. the set of consumers able to access the

network) and the speed available to those who are connected (this should be taken to

be speeds as actually experienced, rather than a hypothetical maximum). Given these

key features, the basic policy question underpinning any CBA of public investment in

HSBB network infrastructure is: What are the characteristics – in terms of key network

features – of the dynamically efficient network rollout, given current community

preferences, technology, costs, fiscal constraints and regulatory settings, and the likely

evolution of these parameters over time?

Whilst the primary purpose of a CBA is not to solve this complex, constrained

optimisation problem, in practical terms assessing various policy options may involve

(either implicitly or explicitly) benchmarking the consequences of various policy options

(including the alternative of “no policy change”) against some socially optimal set of

arrangements (i.e. which maximise net benefits). Hence, insofar as a CBA is intended to

inform the discussion of broadband policy more generally, identifying the broad

characteristics (in terms of coverage and speed) of the efficient rollout path would be a

valuable exercise. Once the characteristics of an efficient path are identified, a CBA of

public investment in HSBB network infrastructure would also need to identify and take

into account the potential effects of possible market failures on coverage and speed, as

10 The analytical framework developed by Little and Mirrlees (1994) can be used to quantify the gains from cost-benefit analysis.


well as realistically assessing the behaviour of relevant government and regulatory

agencies and the likely effect (both positive and negative) they may have on the

evolution of the network’s key features.

1.4. Structure of the Paper

Although many of the basic principles of CBA are set out in detail elsewhere,11 a number

of specific issues are likely to arise in a CBA of investment in HSBB network

infrastructure. This paper therefore aims to provide “broadband-specific” conceptual

guidance for the panel’s CBA by exploring the main sources of the potential economic

impacts of access to faster broadband speeds, as well as providing guidance on how to

estimate these impacts. Where appropriate, commentary is also provided on the likely

economic importance and empirical size of particular impacts.

The paper examines three broad issues relating to public investment in high speed

broadband network infrastructure:

The relevant baseline or “reference scenario”.

Benefits.

Costs.

The paper is structured as follows. Section 2 outlines the considerations that should be

taken into account in designing the reference scenario against which policy changes can

be compared in a CBA. Section 3, which constitutes the bulk of the paper, examines the

conceptual foundations of the possible main benefits of faster broadband speeds.

Section 4 sets out some relevant considerations for direct and indirect costs that may be

associated with infrastructure investment in this area. Section 5 concludes. Advanced

analytical material is provided in the Appendices at the end of the paper.

1.5. Key Analytical Issues

Given the dynamic nature of technology on the supply side, and the rapid development

of applications and the associated benefits on the demand side, uncertainty will be a key

11 See, for example, the Department of Finance’s Handbook of Cost-Benefit Analysis. Other useful references include Boardman et al (2010), Pearce (1983) and Pearce and Nash (1981).


analytical and practical issue in any CBA. To ensure robustness of the CBA, sensitivity

analysis of benefits and costs will be vital. As a general rule, if the results of a CBA vary

wildly with minor changes in assumptions, this suggests that there is a great deal of

uncertainty about the net benefits of the project. This would be valuable information to

decision makers.

Extensive recent literature analyses the economics of the Internet in general, and the

benefits of fast broadband speeds in particular. This literature is not be surveyed in

detail here.12 What clearly emerges from the literature, however, is that broadband

network infrastructure possesses a number of specific economic features.

On the demand side, it is important to note that consumers do not directly value access

to faster speeds. Rather, the goods that are valued directly are services, applications

products and devices. Access to faster broadband speeds is one of many characteristics

that can enhance the value that consumers attach to these end-use products.

Consumers may be able to access a network, but if the access price exceeds their

willingness to pay, they will choose not to take up the services offered. However, if

willingness to pay is uncertain (i.e. subject to unanticipated random shocks –- for

example which may occur when new products come on the market), then consumers

may value the mere fact that they have an option to take up services at some point in

the future. In other words, as shown in Figure 1.1, it may be important to differentiate

between: the option value to consumers of being able to access a HSBB network

(without actually taking up the service); the take-up decision itself; and the demand for

usage of the network’s services (volume and speed of service). Demand for access to

the network (the extensive margin) depends on an individual’s consumer surplus at

existing prices for other goods, compared to the price of access. On the other hand, the

demand for usage depends on the marginal willingness to pay for higher volumes and

faster speeds (given that the decision has already been made to take-up the service),

compared to marginal usage prices. Policy interventions can affect each decision.

12 For a recent Australian example, see Deloitte Access Economics (2013), who estimate that in 2020 the average Australian household will receive $3800 in gross benefits from high speed broadband. However, the authors of this paper carefully note that because their analysis does not include the costs of constructing and operating broadband networks, it does not constitute a cost-benefit analysis; nor was their analysis a comparison of different broadband policies or modes of delivery. Hayes (2011) provides a selective overview of other recent work in this area.


Figure 1.1: Network Access Versus Take-up and Usage

Network Access?

No

TakeupService?

Usage Decision (Volume & Speed)

Yes

NoYes

On the supply side, faster speeds ultimately occur as the result or “output” of a

“production function” or supply chain that involves a number of intermediate stages.

Retail service providers and application/content service providers supply services

directly to end users. In contrast, any HSBB network will lie in the middle of an end-to-

end service, and provide retailers with wholesale access to the network. Retail access to

such a network is necessary, but not sufficient for final consumers to obtain higher

speeds. Indeed, as NBN Co has stated:

“The speeds actually experienced by consumers over fibre, wireless, satellite or copper

will depend on a number of factors including the retail broadband plan they choose, their

equipment and their in premises connection.”13

Access to faster speeds may be complementary to other inputs (such as encoding or

latency), or it may be a substitute. If network access is complementary to other inputs,

then providing access to the network will mean that those other inputs increase,

boosting the ultimate effect of faster network speeds. On the other hand, if access to

the services provided by a network is a substitute for other inputs (such as caching),

then there will be an offsetting reduction in those inputs, and this will mitigate the effect

of being able to access faster speeds on the network.

13 <http://www.nbnco.com.au/nbn-for-home/how-it-works/network-features.html >.


http://www.nbnco.com.au/nbn-for-home/how-it-works/network-features.html

An important implication is that due to responses on the production or supply side,

provision of access to faster speeds via the customer access network may not translate

one-for-one into faster final speeds for consumers. In addition, it may not be

reasonable to make the usual ‘all other things being equal ‘assumption on the supply

side, i.e. it may not be reasonable to assume that building and providing access to a

network will not influence the incentives and behaviour of retail service providers.

Finally, there are a number of good economic reasons to expect that faster network

speeds may yield positive but declining gross marginal benefits. First existing economic

studies suggest that there are, in fact, diminishing marginal benefits to faster speeds.14

Second, since overall service quality will depend on the data requirements for each

broadband activity and whether they are undertaken one at a time or all together,

moving from 25 Mbit/s to 50Mbit/s for example, may make little difference to overall

service quality if the customer’s demand for existing applications, services, products and

devices can be satisfied by a peak requirement of less than 25 Mbit/s. On other hand,

applications that have yet to be invented or widely adopted could require faster

individual speeds to achieve a minimal level of functionality, and so a move from 25

Mbit/s to 50Mbit/s would mean a great deal for service quality if the introduction of

these products into the broadband activity mix required a peak requirement greater

than 25 Mbit/s. For these kinds of combinations of services, it will be important for a

CBA to determine the range of points at which further increases in speed will be unlikely

to significantly improve service quality, and to subject this to sensitivity analysis. Third,

once a domestic broadband network is operating at reasonably high speeds, the links

between the first point of domestic traffic aggregation and the global Internet may act

as one of the main constraints on further improvements in speed. Fourth, as discussed

further in the paper, for some kinds of benefits, basic economic principles suggest that

there will be diminishing marginal returns.

14 For example, Dutz et al (2009) estimate the net consumer benefits from home broadband in the US are on the order of $32 billion per year, whilst the benefits of an increase in broadband speed from 100 times the typical historical speed of dial-up service to 1,000 times dial-up are on the order of $6 billion per year for existing home broadband users. They also document an “experience effect” – consumers who currently enjoy fast speeds value faster speeds over 40 percent more than households who currently have dial-up connections.


2. What Should Project Outcomes be Measured Against? Baseline/Reference Scenario(s)

Cost-benefit analysis assesses the incremental net benefits of a policy, relative to a well-

specified baseline or reference scenario. Hence, as a general proposition, a reference

scenario in a CBA should be transparent and credible. There is little formal literature on

the optimal selection of reference scenarios in CBAs. Both the project scenario and the

reference scenario will involve the construction of forecasts of what is likely to happen a

number of years into the future, and are therefore subject to a great deal of uncertainty.

In public infrastructure projects where there is a relatively low likelihood of public

investment substituting for (or “crowding out”) private investment, the reference

scenario is often relatively obvious and straightforward, and is likely to be based heavily

on the status quo. However, in the case of broadband, the status quo is not a

reasonable baseline assumption. In particular, a baseline scenario in which all

consumers remain at current speeds is unlikely to be a plausible or sensible base case.

Data compiled by the Australian Bureau of Statistics (ABS) and the Organisation for

Economic Co-Operation and Development (OECD) show that access to broadband and

speeds have increased gradually over time in Australia, and suggest that an upward

trend would likely continue in any reference scenario.15

Although this data shows that the Australian situation has been changing over the last

decade, this should not be interpreted as indicating that observed outcomes are

necessarily socially optimal. Rather, the data simply illustrates the changing nature of

the market and highlights the additional complications that this may entail for a CBA,

particularly for specifying a reference scenario.

Given the dynamic and uncertain nature of the future evolution of broadband

characteristics and take-up rates, one useful way to think about the reference and policy

scenarios is that higher broadband speeds for a large proportion of the population may

be achieved in both scenarios but that outcomes are accelerated and benefits may be

realised sooner in some scenarios. Viewed in this way, the task of a CBA potentially

15 See, for example Australian Bureau of Statistics, Cat. No. 8146.0, Household Use of Information Technology, Australia, 2012-13; ABS Cat. 8153.0. Internet Activity, Australia, June 2013 and <http://www.oecd.org/sti/broadband/oecdbroadbandportal.htm > particularly Tables 1g(1) and 1g(2).


http://www.oecd.org/sti/broadband/oecdbroadbandportal.htm

becomes less complicated: it is simply to compare similar community benefits that may

be realised over different timeframes, with different costs imposed on the community.

Two major factors are likely to complicate this approach. First, there is the question of

what should be assumed about the starting point for policy. Current policy

arrangements may be irreversible and therefore involve sunk costs – which should not

be counted in any CBA – whilst other policy settings may be reversed or renegotiated in

the short or medium term. Second, there is the question of what regulatory

arrangements will apply in the policy and reference scenarios. Regulation affects

incentives on both the supply side (by altering the timing and extent of investment) as

well as the demand side (by altering prices and take-up rates). Careful consideration will

need to be given to both factors, and ideally a range of scenarios should be examined

and subjected to sensitivity analysis.

Given recent broadband developments, it is crucial for any CBA to ascertain, as a first

step, the extent to which household and business broadband activities involving existing

applications, services, products and devices – as well as those that are likely to be

developed and made available and taken up over the medium term – are able to take

place with an acceptable level of functionality at speeds that are either already

available, or that are likely to become available, using existing infrastructure and

technology, or using infrastructure that is likely to be constructed and technological

changes that are likely to occur over the medium term in the absence of major policy

changes.

On the demand side these are essentially technological questions, which require an

examination of peak transmission requirements of various services and combinations of

services (such as high quality video conferencing, IPTV, streamed video, video and

software downloads and general web usage), the extent to which these transmission

requirements are likely to change in the medium term due to technological innovation

(e.g. video compression) or moves towards “content-rich” environments, and the extent

to which increases in download and upload speeds are likely to yield economically

noticeable changes in existing overall service quality.16

16 Relevant here is the work of Robert Kenny and Tom Broughton, Domestic demand for bandwidth, an approach to forecasting requirements for period 2013–2023, see


Similarly, on the supply side, answering these questions will require an examination and

assessment of existing infrastructure, including the download and upload speeds that

can be experienced by customers using copper lines connected to ADSL2+ enabled

exchanges, and the coverage and capability of existing hybrid fibre coaxial (HFC)

networks, fixed wireless networks, and 3G and 4G mobile networks. It will also require

an assessment of likely future supply side developments (e.g. developments in wireless

and satellite technology, increased use of VDSL) that may occur in the absence of major

policy changes.17

It is impossible to precisely determine the dynamically efficient path of high speed

broadband infrastructure investment in an Australian context (taking into account

demand and supply side uncertainty, irreversibility of investment, and the potentially

large number of option values that are embedded in investment decisions). However, it

would be highly desirable for a CBA to determine the most important economic features

of such a dynamically efficient path – including the economic trade-offs that are

involved, and the incentives on the demand and supply side of the relevant markets.

Given the results of such an analysis, it would also be desirable to examine and

determine the extent to which market outcomes – supported by appropriate regulation

– will deliver the features that characterise the dynamically efficient investment path.

Such features include the timing of aggregate investment, the extent of population

coverage over time, the extent of competition, pricing arrangements, capacity choice

and congestion, download and upload speeds, as well as other characteristics.

Addressing these issues necessitates the construction of a credible reference scenario,

which in turn involves a careful consideration. Given that there is a significant amount

of uncertainty regarding the precise evolution of technology, as well as the development

of consumer applications and devices over the medium term, it would be preferable to

develop a suite of different reference scenarios, each of which can ultimately be used as

an input into sensitivity analysis.

<http://www.commcham.com/storage/publications/BSG-Domestic-demand-for-bandwidth.pdf>.

17 Much of the work for such an assessment has recently been carried out by the Australian Government; see the Department of Communications’ 2013 report, Broadband Availability and Quality.


http://www.commcham.com/storage/publications/BSG-Domestic-demand-for-bandwidth.pdf

Factors that should be addressed in the construction of these scenarios include:

The current state of Australia’s broadband market, and the economic drivers of

the evolution of the market to date.

The evolution of private sector telecommunications infrastructure investment in

Australia, and the incentives that competition and market forces have provided

for such investment.

The role that regulation has played in influencing the evolution of market

outcomes, including its influence on incentives for investment, consumer prices,

capacity, network coverage and speed.

Given supply and demand side uncertainties, this paper is deliberately non-prescriptive

regarding the specific choice of reference scenarios. However, at the minimum, the CBA

could examine three broad sets of reference scenarios:

Pessimistic scenarios in which investment in – and take-up of – faster speeds are

inefficiently delayed to a significant extent, or where the breadth of coverage is

significantly inefficiently narrow. In constructing this scenario it is crucial to

carefully identify the reasons that may drive such an outcome – that is, the

market or regulatory failures that are likely lead to inefficient delay.

Intermediate baseline scenarios, in which market outcomes are, in theory, likely

to be dynamically efficient. In developing this scenario it would be important to

explore the reasons why market failures are likely to be minimal, and the policy

and regulatory settings that are likely to lead to such an outcome.

Optimistic or overinvestment scenarios, in which investment in – and take-up of

– faster broadband occurs more rapidly than the dynamically efficient path, or

where network coverage is extended to areas where it is inefficient to do so.

Again, in constructing such as scenario it will be important to carefully identify

the market or regulatory failures that may lead to inefficient overinvestment.

Different features from a subset of these scenarios could be chosen and combined with

each other to form hybrid baseline scenarios. The extent to which such baseline

scenario-building is employed is ultimately a matter of judgement for the CBA analyst.


The quantitative results of the implicit optimisation exercise undertaken in a CBA will be

a function of the assumed parameters (i.e. the reference scenario). This is a strength of

a CBA, rather than a weakness, as results can be mapped clearly and transparently back

to the assumptions that are made. On the other hand, it is possible that some of the

qualitative results of a CBA may not vary greatly with the assumed reference scenario.

For example, it may be the case that for all reasonably likely paths of willingness to pay

and costs, a particular policy never yields positive net benefits. Importantly, if there is a

great deal of uncertainty about the reference scenario (or uncertainty about other

modelling parameters or assumptions) and the qualitative features of the CBA vary

widely with these assumptions, then this suggests that there is a great deal of risk

associated with the project. This is likely to be useful information for a decision maker.

Once these reference scenarios have been constructed, they can then be compared

against the likely outcomes under various policy scenarios. The way in which this can be

done is illustrated in Table 2.1 below. The assumptions and parameters used to develop

such scenarios could also form part of the project scenarios. For example, one project

scenario could be that private suppliers target consumers with willingness to pay greater

than the incremental costs of higher broadband speeds, whilst the government also

mandates a community service obligation (CSO) to serve some or all other consumers.


Table 2.1: Two-Way Classification of Policy Alternatives and Scenarios

Private

Investment

Scenarios

Policy Alternatives

Policy A

(No policy

change)

Policy B Policy C Policy D

1: Low $0

2: Medium $0

3: High $0

Note: Entries in the cells in each row are the net social benefits of different policies relative to the relevant

baseline in that row. In some instances combinations of policies may be involved. Not every cell needs to

be filled with an estimate.

In comparing baseline scenarios against policy scenarios, it is important that the CBA

examine and realistically assess the extent to which policy changes are likely to achieve

their stated goals, and the extent to which they will actually address the sources of

market or regulatory failure that are assumed to drive the evolution of outcomes in the

baseline scenario. Policy changes that fail to adequately target these sources of failure

are less likely to yield incremental net benefits relative to the baseline, and under some

circumstances may actually yield negative incremental benefits even assuming a

relatively pessimistic baseline scenario.


3. BenefitsThere are two broad groups who may benefit from faster broadband speeds, and for

which private willingness to pay could therefore be estimated:

Consumers – individuals and households for whom faster speeds directly

enhances the value of existing and new entertainment, educational and other

applications.

Producers – small and large businesses, for whom faster upload and download

speeds may result in higher profits.

Conceptually, faster broadband speeds may provide a range of benefits to consumers

and producers. Consumers and producers may experience greater benefits from using

existing products, and are also likely to benefit from the ability to use new products.

Faster upload speeds for business may result in pure time savings uploading

information, whilst households may experience similar gains as a result of both faster

upload and download speeds. Other possible benefits include reduced transaction

costs, cost savings related to shorter travel times, and possible productivity

improvements. Finally, faster broadband speeds, by reducing effective “travel costs”

(where these costs encompass a broad range of factors that may inhibit worker

flexibility) may improve labour force participation, enhancing the ability of workers to

take advantage of employment opportunities that would otherwise not be present due

to the constraints imposed by slow broadband speeds.

This section examines these sources of benefits. Any CBA will have to acknowledge that

there is a considerable amount of uncertainty regarding:

The size or quantum of benefits.

The geographical/spatial pattern of benefits – e.g. urban versus regional.

The intertemporal pattern of benefits.

This section also explores some of the issues involved in estimating benefits at a point in

time as well as over time, and social benefits from faster broadband speeds that may

not be reflected in estimates of private willingness to pay.


3.1. The Indirect Demand for Faster Broadband Speeds

On the demand side, it is important to note that consumers do not directly value access

to faster speeds. Rather, the goods that are valued directly are services, applications

products and devices. Access to faster broadband speeds is one of many characteristics

that can enhance the value that consumers attach to these end-use products. Even in

the case of faster download speeds and direct travel cost savings (explored further

below), faster speeds not valued directly – they are only valued because they open up

opportunities for more downloads, greater leisure time or longer working hours (which

allow consumers to increase their labour income and consumption possibilities).

To see this more clearly, consider an extreme case in which there were no new or

existing applications that required very fast speeds. Then consumers would obviously

attach no value to accessing a network that promised further speed upgrades. Hence,

the value attached to access to faster speeds is an imputed or derived value, and the

marginal valuation curve for network access and the faster speeds it may provide (or the

“demand curve”) is a derived demand curve.

To understand this analytically, consider Willig’s (1978) approach to valuing changes in

the attributes of goods.18 Holding prices and income constant, the welfare gain from

being able to access a network with a greater speed of (compared to the current

network speed of ) can be estimated in one of two ways:

1. Willingness to pay can be estimated directly.

2. Willingness to pay can be indirectly estimated by adding the changes in

consumer surpluses in markets for various products and services when a change

in speeds induces a shift of those demand curves, assuming prices and income

are held fixed.

The basic idea is illustrated in Figure 3.2 below, where an increase in broadband speed

induces an increase in demand for good A (e.g. streamed video), but reduces demand

for good B (e.g. standard video). The change in consumer surplus in market A is the

change in the area underneath the demand curve for good A, whereas the change in

18 See also Johansson (1987), Chapter 6.


consumer surplus in market B is the change in the area underneath the demand curve

for good B. The overall effect on consumer welfare of this change in attributes or

characteristics is the sum of these two changes.

Figure 3.2: Illustration of the Effect of a Marginal Increase in Broadband Speeds on

Welfare and Demand for Other Products

0AP

1Ax

1Bx

11

BDAD

Market A Market B

0Bx

APBP

0BP

00

0Ax

'BD'AD

ACSBCS

Note that since the welfare effects of changes in Internet speeds are isolated, prices and

incomes are assumed not to change, and so the consumer’s overall spending is also

assumed not to change. Instead of overall spending changing, there is a shift in

spending towards goods whose marginal value has increased as a result of faster

speeds, away from goods whose marginal value has fallen. This analysis therefore

suggests that estimating changes in overall spending on final goods and services – i.e.

gross domestic product (GDP) – may not completely capture the full welfare effects of

changes in product quality and attributes in general, and the welfare effects of faster

broadband speeds in particular.19

For new goods, by definition the marginal cost exceeds the greatest marginal willingness

to pay. In this case, the above approach that directly links changes in demand to

willingness to pay for faster speeds needs to be modified. Suppose, for example, that

19 This does not mean that changes in broadband speeds will have no effect on GDP. The point is that changes in GDP are neither a necessary nor a sufficient condition for changes in broadband speeds to affect economic wellbeing.


the marginal cost of a new good is so high that even with an increase in demand

following an increase in speed, the market equilibrium quantity is still zero. Then, even

though demand has changed, no benefits are in fact realised. In Figure 3.3 below, the

initial price of good B (which would reflect its marginal production costs) is so high that

there is no demand for it at slow speeds. The increase in speed results in positive

demand, but the benefits need to be computed carefully. The main conclusion is that

the marginal willingness to pay for faster speeds will depend, among other things, upon

current speeds, prices, and income.

Figure 3.3: Illustration of the Effect of a Marginal Increase in Broadband Speeds on

Welfare and Demand for Other Products: The Case of a New Good

0AP

1Ax

1Bx

1

1

BDAD

Market A Market B

APBP

0BP

0

0

0Ax

'BD'AD

ACS

BCS

It may also be possible that faster broadband speeds may increase the variety of

products available to consumers. The above framework can be extended to cover this

case. Since such improvements in variety directly increase consumer and/or producer

welfare, it is reasonable to expect that a large share of these benefits is likely to be

captured in consumer and producer willingness to pay for faster broadband speeds.


3.2. Pure Time SavingsFaster broadband speeds may have a pure time saving effect with respect to

downloading information, which may result in both work and leisure (i.e. non-work)

time savings. Ergas and Robson (2009) develop a simple model which illustrates this

idea, using the simple time-allocation model originally developed by Becker (1965).20 In

this model, a consumer spends time either working or downloading. In that model the

consumer has a lump-sum income of Y and earns labour income at a nominal wage rate

of w. Let L be the number of hours of labour supplied. Assuming that the consumer

consumes both downloads and other consumption goods, their combined time and

budget constraint is:

The consumer maximises utility from consumption goods and the quantity of

downloads.21 The basic model is illustrated below.

20 Goolsbee and Klenow (2006) use Becker’s framework to compute the consumer benefits of access to the Internet, but they do not examine the welfare effects of greater download speeds.

21 The assumption that workers either work or download may be unrealistic. For example, individuals would do other work while waiting for downloads. The same argument applies for savings in leisure time from faster downloads. In these cases, the pure time savings from faster download speeds would clearly be smaller than those described in the model.


Figure 3.4: Faster Broadband Speeds in a Simple Time-Use Model

Consumption c

Tpw

pY

max ,0ipY sTp p

sTDownloads (D)

Constraint: iDY w T pc p Ds

Slope of Constraint is: ipdc wdD sp p

Source: Ergas and Robson (2009)

The consumer derives incremental benefits from an increase in download speeds, as this

frees up additional time for working, may boost the individual’s labour supply and widen

the individual’s consumption possibilities. The effect of an increase in speed in this

model is shown in Figure 3.4 below.

The increase in speed has both an income and substitution effect, altering the relative

returns to leisure. The volume of downloads increases, but time spent downloading

may either rise or fall, depending on the elasticity of the volume of downloads with

respect to changes in speed. Overall, faster speeds create marginal benefits that

depend inversely on the square of the speed.


Figure 3.5: The Impact of Faster Broadband Speeds on Consumer Welfare

Consumption c

Tpw

pY

0s T 1s T Downloads D

Source: Ergas and Robson (2009)

3.3. Reduced Transaction Costs

Faster broadband speeds may lower transaction costs in markets (e.g. the costs of

searching for goods and services). However, since reductions in transaction costs

increase consumer and/or producer surplus, a significant share of these benefits may be

captured in consumer and producer measures of willingness to pay for faster broadband

speeds. Hence, even if such effects can be identified and measured, a great deal of care

needs to be taken to ensure that there is no double counting of benefits.

In markets where transaction or time costs are significant, consumer demand depends

on the full price of the good (the money price, plus the transaction costs needed to

obtain the good). Similarly, the full price obtained by the seller is the money price

received from the buyer, less the transaction costs associated with finding a suitable

buyer, negotiating, and so on. Welfare in such markets depends on the sum of the

transaction costs on each side of the market. If transaction costs fall, then the incidence

is shared between buyers and sellers, depending on the relative size of demand and

supply elasticities. It is possible that money prices could rise following a fall in


transaction costs – although overall consumers would still be better off because the full

price of the good would have declined.22

3.4. Travel Time Savings

Faster broadband speeds may lower travel times for individuals travelling to and from

their place of work. The effects of shorter travel times on labour supply are discussed in

section below. Opportunity cost is the key driver of time costs. That is, conceptually,

the value of time saved depends on the utility (and disutility) experienced during travel,

compared with the value of the next best alternative activity. More generally, faster

broadband speeds may allow workers greater flexibility in arranging their work

schedules to fit in with family and other commitments, inducing individuals to explore

employment opportunities that were previously unavailable to them. Faster network

speeds may also allow individuals to work across state and international borders

effectively, and hence improve the ability of individuals to collaborate and compete

internationally. These improvements, which come about as a result of a reduction in

“travel costs” (where these costs are broadly defined and include vehicle operating

costs, parking costs, and the costs of inflexibility)23 would result in an expansion in

labour force participation. However, since such reductions in travel costs directly

increase consumer and/or producer wellbeing, a significant share of these benefits may

be captured in consumer and producer willingness to pay for faster broadband speeds.

Again, care needs to be taken to avoid double counting.

3.5. Productivity Improvements

Faster broadband speeds may increase the productivity of existing factors of production

such as labour and capital, leading to a direct increase in GDP. Increases in total factor

productivity (TFP) feed directly into reductions in unit costs of production (holding

22 This proposition is demonstrated in numerous economics textbooks. See, for example, Stockman (1996) pages 143–144. A more detailed analysis demonstrating these and other results on transaction costs can be found in Chapter 1 of Robson (2012).

23 If the negative effect on physical commuting is sufficiently large, there may also be reduced congestion costs.


wages and other input prices constant),24 and as such are likely to be captured in

producer willingness to pay for faster broadband speeds.

As explained in Appendix 2, the welfare effects of any productivity gains do not depend

on the effect of productivity changes on employment. Hence, in measuring any welfare

gains from improvements in total factor productivity, there is no need to measure the

number of jobs that are created or destroyed. Section explains the circumstances

under which changes in labour supply may have important implications for a CBA and

may need to be computed and included.

3.6. Estimation of Private Willingness to Pay

As outlined at the beginning of section 3, the benefits of faster broadband speeds will

likely accrue to both consumers and producers. The previous sections examined some

of the conceptual microeconomic foundations of faster broadband speeds. The analysis

demonstrated that these can be usefully studied using the “characteristics” approach as

well as other common economic approaches, and can be incorporated into standard

microeconomic models of consumer choice. Conceptually the direct drivers of

household willingness to pay for faster speeds are likely to derive from time savings

accessing existing products, services, applications, as well as making new products,

services and applications available, e.g. new health and educational products. Faster

upload and download speeds may also lower business costs and improve profits, lower

consumer prices, or some combination of both. The theoretical analysis suggests that

widely used econometric techniques may be used to estimate willingness to pay for

faster broadband speeds.

3.6.1. Hedonic Regression Using Market Data

One approach to estimating willingness to pay for faster speeds is to use aggregate time

series market data to estimate market demand curves, from which the marginal effect

of faster speeds can be ascertained. This approach can be summarised very briefly as

follows. Suppose that actual data on the (logarithm of) prices (pt), speeds (st), and a

vector of other package characteristics (zt) was available. A posited relationship

between price and these variables might take the log-linear form:

24 Harberger (1998) explores this interpretation of changes in total factor productivity.


The basic idea of hedonic regression methods is to use the coefficient on speed in to

provide some indication of the “implicit price” or marginal willingness to pay for faster

speeds, holding all other variables constant. This “hedonic” approach using market data

has been applied in a wide range of settings, including to the valuation of housing

characteristics, automobiles and other consumer goods.25

3.6.2. Discrete Choice Estimation Using Survey Data

An alternative approach to estimating willingness to pay for faster speeds is to use

discrete choice econometric methods. These may be applied to market data at a single

point in time (assuming the data set is sufficiently rich). Alternatively, data could be

collected using a carefully designed consumer survey.

There is a vast literature on these methods and their applications, but the basic

approach applied to broadband speeds can be briefly summarised as follows.26 In a

discrete choice or random utility estimation framework, consumers are confronted with

a set of J different broadband packages, labelled , and are asked to choose

one of them. Let be the direct utility gained by the individual when they choose

package j. This direct utility is assumed to be a function of observable and unobservable

factors:

where only one of the packages is actually chosen, so that . Here, is a vector

of characteristics of package j, and is a composite other good, whilst is a random

disturbance term reflecting unobserved characteristics. Let the price of package j be

25 A number of obvious difficulties arise in estimating an equation such as and isolating consumer willingness to pay. For example, this ignores the supply side and the marginal cost of producing different attributes. There is a vast literature exploring these techniques. For a summary of the theory behind the hedonic approach, see Rosen (2002). Triplett (2006) provides an overview of examples and information technology (IT) related applications, and outlines the practical difficulties and econometric issues that are typically encountered when using hedonic methods.

26 McFadden (1999) is a basic reference for the material in this section. See also Bateman, Bockstael and McConnell (2007).


. For convenience, assume that if alternative j is chosen, then ; otherwise .

If the individual chooses alternative j, indirect utility is then:

where it is assumed that the characteristics of packages that have not been chosen do

not affect utility.

As shown in the Appendix 3, under certain technical assumptions the expected welfare

effects of (willingness to pay for) faster broadband speeds can be directly recovered and

computed from the estimated parameters. However, if alternative assumptions are

employed, then it is not possible to obtain closed form expressions for willingness to

pay, and the use of numerical methods would be required.

3.7. Benefits Over Time

Depending on survey design, estimates from a discrete choice framework may reflect

consumer judgements regarding the present value of their willingness to pay for a

stream of benefits over time. Alternatively, such an analysis could be used to estimate

the willingness to pay for monthly or yearly access to faster speeds. The intertemporal

pattern of demand for applications, products and services will drive the evolution and

growth of aggregate benefits of faster speeds over time. Since any large public

infrastructure project will typically take many years to construct and will likely have high

upfront costs, it becomes crucial to specify exactly when future benefits are likely to

accrue in both the policy and baseline scenarios. Therefore, credible projections of

likely take-up rates are required, and these should be subjected to detailed sensitivity

analysis.

Forecasts and projections of aggregate take-up from NBN Co and from NBN Co.’s

December 2013 Strategic Review may assist with the construction of such projections.

However, in utilising these forecasts and projections in a CBA, it would be necessary to

clarify the assumptions on which they are based and the methods used to generate

them, so that they can be suitably modified under different project and reference

scenarios, and sensitivity analysis can be conducted.

3.7.1. Product/Innovation Diffusion Models


One approach to forecasting likely take-up rates is to study the patterns of similar

technologies, as well as international evidence on broadband take-up rates over time.

In the marketing and forecasting literature new product or innovation diffusion models

have been specifically developed and used for this purpose.27 Generally speaking, these

are pure time series forecasting approaches, but which sometimes incorporate other

variables such as price and advertising expenditure.

Product diffusion curves are typically assumed to follow an “S-shaped” path: there is

rapid take-up initially, but then take-up rates slow down as the market becomes fully

saturated. For example, a widely used model is the logistic diffusion model. Let c be the

take-up or adoption rate, and let be the rate of change in take-up over time. Then

according to the logistic model, the growth rate of take-up obeys:

where , and where is an upper bound on the take-up rate. As this

model results in the widely used Gompertz function:

Figure 3.6 below plots an example of the logistic production diffusion curve, whilst

Figure 3.6 plots the change in the take-up rate implied by such a curve. “S-shape” take-

up paths have been estimated in telecommunications markets (e.g. mobile phones) and

this approach may be usefully applied to broadband take-up rates. There are a wide

range of flexible approaches which could be used.

Figure 3.6: Example of a Logistic Product Diffusion Curve (=0.3, =2).

27 For a survey of the extensive forecasting literature in this area, see Meade and Islam (2006). Geroski (2000) reviews the literature on the microfoundations of diffusion models.


0

10

20

30

40

50

60

70

80

90

100

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41

Time

Take

up

Figure 3.7: Change in Take-up Rates Implied by the Logistic Product Diffusion Curve

(=0.3, =2).

0

1

2

3

4

5

6

7

8

9

10

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

Time

Cha

nge

in T

akeu

p R

ate

One of the main concerns with using such curves in a CBA is that they may fail to specify

the “deep parameters” (i.e. underlying consumer preferences) that are supposed to

have generated the forecast take-up path. Appendix 4 shows that if benefits take a

special functional form, then these “S-shaped” take-up paths can be derived from a

simple intertemporal consumption optimisation problem. The main point of the

analysis in the appendix is to show that by making an assumption about the path of

adoption, a CBA is also implicitly making an assumption about the evolution of


consumption benefits over time. Assumptions about one cannot be made

independently of the other, and they should be consistent with each other.


3.8. Network Effects

A further possible source of net benefits that may be important for the analysis of faster

broadband speeds falls under the general heading of “network effects”. In the context

of a CBA of broadband network infrastructure, attention has focused on two

conceptually separate effects: direct demand side network externalities, and indirect

demand side network externalities. The next two subsections examine these effects

separately.

3.8.1. Direct Network Externalities

Direct network effects are said to be present when an individual’s marginal benefit from

using the network increases with the number of other users of the same network.

There is an extensive literature analysing the demand side externalities that may be

associated with Internet use [see, for example, Shapiro and Varian (1999) or Varian

Farell and Shapiro (2004)]. In other economic contexts (such as the analysis of social

norms or peer or group effects on economic behaviour), these effects are referred to as

“strong complementarities” [Becker and Murphy (2000)]. The basic idea is that for a

given speed, consumer marginal willingness to pay may depend in some way on the

number of other users on the network. In some cases, marginal social benefits of a

larger network may exceed private marginal willingness to pay for access to the

network. On the other hand, at some point as more users are added, congestion may

occur, reducing private marginal willingness to pay below marginal social benefits.

In theory, the presence of strong positive demand side network externalities may imply

that in the absence of policy interventions there will be an inefficiently low number of

broadband users, as each user imposes an uncompensated benefit on the others. On

the other hand if, at the efficient network size, the marginal externality is negative,

there will be too many network users.

It is important to remember that direct network externalities typically refer to the

demand side rather than the supply side. If there is an existing network and the

presence of a direct demand-side externality leads to an inefficiently small network of

adopters (so that there is excess network capacity) then it is unclear why building


additional network capacity would improve network utilisation. In addition, many users

of broadband networks only interact with a small group of other users (such as close

friends or family members), rather than the entire network. This increases the

likelihood that users will make private arrangements to internalise any direct network

externalities that may exist between them.

Furthermore, instances in which there a large number of interactions between network

users are likely to involve commercial transactions – in which case externalities are once

again more likely to be internalised via market arrangements. For example, any

government project is likely to be a wholesale network, not a retail network.

Intermediaries (retail service providers) will likely provide a range of plans with various

speeds that can exclude some users from accessing faster speeds. They may be able to

commit to providing faster speeds to consumers who exhibit network effects, and then

charge users a price so that users obtain their reservation utility [see, for example, Segal

(1999)]. In that scenario, any network externalities would effectively be internalised and

could be captured by measuring intermediaries’ willingness to pay.

One of the tasks of a CBA would be to examine, from an empirical perspective, the

extent to which current broadband adoption rates in Australia are inefficiently low due

to demand-side network externalities, and the extent to which faster speeds may

impact upon any network externalities. Whilst network effects typically refer purely to

increases in the number of users on a given network, the logic of network externalities

may also apply – with appropriate modifications – to changes in network functionality.

For example, following an increase in network speeds, some users may able to broaden

their interactions with other users (who may already be on the ‘network’ in a physically

connected sense) using a new technology (e.g. video) that was not previously available.

In this scenario, the new interactions would simply not have been possible but for the

increase in network speed.

A related concern regarding network effects is the extent to which they may cause

estimates of private willingness to pay for faster speeds to differ from the social benefits

of faster speeds.28 If there are strong network effects present and individuals are asked

to report their willingness to pay for faster speeds, then their stated willingness to pay is

28 See, for example, Quiggin (2013).


likely to be based on their expectation of the number of users of the network – even if

they are not explicitly asked about this in a survey question. This estimate could be

larger or smaller than the efficient number of users, and so the implications for the

results of willingness to pay estimates are ambiguous. In any case, it may be possible to

use discrete choice econometric methods to directly estimate the size of network

effects, and these could then be incorporated into a CBA. There is a growing empirical

literature that provides guidance on how these kinds of network interdependencies can

be accounted for and estimated using standard discrete choice econometric

techniques.29

Appendix 5 contains a theoretical analysis of network effects. One of the conclusions of

this analysis is that the incentive for the private sector to provide access to faster

maximum speeds depends on the marginal willingness to pay for higher maximum

speeds of the marginal consumer, whereas efficiency is concerned with the average

marginal willingness to pay, taken over the entire network. Even in the presence of

direct network externalities, it is not at all clear that the marginal consumer would be

willing to pay a lower amount for faster maximum speeds than the average consumer.

Hence, even if the presence of network externalities creates a discrepancy between

market outcomes and the socially efficient allocation of resources, it is not clear what

the sign or size of that discrepancy actually is.

If the network is subject to congestion effects (i.e. negative marginal network

externalities), matters are even less clear. If there are too many network users in a

market setting and the network becomes congested, then we are in a second best

economic environment. In this setting, commercial realities could mean that firms may

try to offset some of the congestion effects and compete for the marginal customer by

offering inefficiently fast maximum download speeds.

29 See, for example, Brock and Durlauf (2001).


3.8.2. Indirect Network Externalities

Indirect network externalities arise when a larger number of network users means that a

larger range of associated applications, products, services and devices can be supported,

or that as the market expands these associated products can be produced at lower unit

costs and therefore sold at lower prices to consumers. They differ from direct

productivity gains identified earlier, in that they do not result in a downward shift in a

firm’s cost curve – instead, they involve a movement along a downward sloping average

cost curve. As a number of authors have noted,30 it is more appropriate to treat these

effects as pecuniary externalities (i.e. effects that are mediated through the price

system) rather than technological externalities. For the purposes of welfare analysis,

these kinds of externalities can be ignored, as the gains to consumers from lower prices

are merely transfers from producers.

Consider, for example, the case in which a larger number of network users translates

into a large number of users of a particular “app”, and that this drives down the unit

costs of supplying the “app”. Analytically, this is simply an example of a competitive

industry which exhibits a declining long run supply curve. As the demand curve for the

good shifts out, input prices fall, and marginal product costs fall. The reduction in prices

is a transfer from the owners of the scarce factors of production to consumers, and

there is no overall change in welfare.

3.9. Fiscal Effects

Changes in broadband speeds may have implications for the pattern of tax revenue and

government spending in the economy as a result of changes in private demands. These

changes in revenues may or may not have welfare consequences. These issues are dealt

with further below.

There is an additional, conceptually separate class of welfare effects to consider in

relation to government-provided goods and services. Faster broadband speeds may

reduce the costs of supplying publicly provided private goods such as health and

education (some of which have public good characteristics, but which may be more

30 See, for example, Liebowitz and Margolis (1995).


appropriately regarded as merit goods), may improve the quality of existing services, or

may allow new services to be offered. In these cases, overall economic benefits depend,

among other things, on whether those services are provided efficiently (both in a cost

sense and in a wider economic sense).

Many existing studies have attempted to estimate the benefits that faster broadband

speeds may bring in the form of new or higher quality government services, but they

suffer from a major drawback: they do not provide estimates of the costs that are likely

to be involved in delivering those services. If faster broadband speeds allow

governments to provide new or higher quality services in health, for example, then new

medical equipment may be needed, doctors and nurses may need to be trained in new

techniques, and patients may need to purchase their own equipment. Failing to

subtract the costs associated with new or higher quality services will produce incorrect

estimates in any CBA.

Claims about reductions in government spending should also be treated with caution.

Consider Figure 3.8 below, which assumes that taxes impose no deadweight cost, so

that the optimal provision of a public good obeys the standard Samuelson rule (i.e.

supply up to the point where the social marginal benefits equal the marginal resource

costs). Suppose that faster broadband speeds reduce the marginal cost of providing the

relevant good (MC0 to MC1). Then in the Figure below, it is not only optimal to increase

the level of G that is provided (from G0* to G1

*); it is also optimal to increase spending on

the good. In this example, although the reduction in unit costs reduces spending

(reducing it be the shaded blue area), efficiency requires that more of this good be

supplied, which increases spending (by the shaded pink area). Overall, spending

increases in this example. But in general the sign and size of the effect depend on the

elasticity of the social marginal benefit curve. If this curve is relatively inelastic, then a

fall in costs will reduce spending. The welfare gain here is the gain in social benefits,

which is equal to the blue shaded area plus the green shaded area. The analysis

suggests that although changes in government spending and efficiency effects are

obviously related, they are conceptually very different and so it is important to treat

them separately.


Figure 3.8: The Effects of Lower Unit Costs on Optimal Spending and Provision of a

Publicly Provided Good

Quantity

Marginal Benefit, Marginal Cost

*0G

*1G

0MC

1MC

MB

This point is illustrated further in Figure 3.9 below, which modifies the previous case by

assuming that the taxes needed to fund public goods are distortionary (this point is

discussed further below). The welfare gain from lower costs is now the area bounded

by the points a, b, c, and d. Overall, even though unit costs fall, spending still rises – and

this is efficient.


Figure 3.9: The Effects of Lower Unit Costs on Optimal Spending and Provision of a

Publicly Provided Good – Taxes are Distortionary

Quantity


*0G

*1G

0MC

1MC

MB

ab

cd

In these two examples, government was assumed to be acting efficiently and responding

in an efficient manner to changes in costs. If this is not the case, then the link between

reductions in costs, spending and efficiency becomes even weaker and more tenuous.

Hence, in the case of publicly provided goods, looking solely at changes in government

spending induced by public investment in an HSBB network is likely to be a poor proxy

for the community benefits of faster broadband speeds.


3.10. Wider Economic Benefits (WEBs)

Wider economic benefits are those not typically captured elsewhere in a standard CBA

(i.e. by estimating individual consumer and producer willingness to pay). This

subsection examines three wider economic benefits that are typically considered in

CBAs.

3.10.1. Economies of Agglomeration

In the context of urban economics, technological economies of agglomeration are said

to arise when a business or worker’s productivity is higher if they locate in a large city

rather than in a smaller city (or, alternatively, if they locate within a “cluster” of similar

workers or businesses).31 It is typically argued that these agglomeration effects act as

positive technological externalities that occur when a new road or railway is

constructed.

Similarly, “virtual” economies of agglomeration (i.e. the counterpart, in an online

environment, of these more traditional spatial agglomeration effects) refer to the

possibility that faster broadband speeds may lead to similar productivity benefits from

“clustering”, but without the need for firms or workers to be physically located in the

same geographic area.32

In urban economics the standard approach is that reducing transport costs increases the

extent to which activities are physically linked to each other, and hence individuals are

better able to take advantage of any agglomeration economies. However, whilst such

effects are indeed likely to be present, they need to be treated with a great deal of care

in a CBA: to generate the additional economies of agglomeration, workers or firms must

have located from one place to another, and a CBA should take account of the

agglomeration diseconomies that would presumably have occurred in the location from

which workers and firms have relocated. Only the net agglomeration effect – which

could be negative – should be counted in a CBA.

31 See, for example, Glaeser (2008), Small and Verhoef (2007) and Brueckner (2011)

32 Plum Consulting (2008) contains a brief discussion of this idea in the context of broadband policy.


Similar considerations are likely to apply to virtual economies of agglomeration. If

virtual “clustering” is a substitute for physical “clustering”, then it is only the net

agglomeration effect that should be counted in a CBA. For example, if workers decide to

no longer commute to a large city and instead work from a regional location and

communicate via teleconference over an HSBB connection, then, although this may

produce virtual agglomeration economies, it would have the opposite effect on physical

agglomeration economies. Whilst the workers themselves would clearly be better off

(having revealed a preference for not travelling to the city), the inclusion of economies

of agglomeration in a CBA is an attempt to capture external benefits which have not

been captured in private benefits. It is not obvious whether the net external effect

would be positive.

On the other hand, the ability to engage in “virtual clustering” may be complementary

to physical clustering. That is, the ability of workers or firms to access HSBB may make

cities even more attractive places to work. In this case, HSBB may produce further

physical economies of agglomeration (which, as before, would need to be compared

with physical diseconomies as workers or firms move from regional areas to cities).

Overall, it is not clear what the sign of “virtual” economies of agglomeration would

actually be, nor the size of these effects. Therefore, as is the case with more traditional

physical economies of agglomeration, such effects should be treated with a great deal of

care in any CBA. In any case, in a CBA the ultimate question is whether such effects,

even if they are positive, are likely to be greater in the project scenario compared to the

reference scenarios, and if they are, whether these gains justify the additional costs that

may be associated with the project.

Finally, even if there were significant “virtual” agglomeration economies, there are a

number of significant practical obstacles to be overcome before these could be

accurately estimated. For example, it would be necessary to separate productivity

differences due to virtual linkages from those due to more traditional transport linkages.

There could also be a risk of double counting with respect to conventional benefits and

benefits from network economies.


3.10.2. Labour Supply and Taxation

It is often argued that faster broadband speeds will increase the supply of labour.33 This

may not only have a beneficial economic effect in its own right, but may also increase

the revenue from taxes on labour income – which should be counted as an additional

source of benefits.

Both effects can be examined using basic principles of economics. The simple time use

model of the effects of broadband speeds, explored earlier in . Pure Time Savings,

indicates that faster broadband may increase labour supply. In this model, the

consumer’s entire non-work time is assumed to be downloading. Faster broadband

speeds make this form of leisure more valuable but because more time becomes

available as a result of faster speeds, this may also increase labour supply.

If faster broadband speeds reduce work travel times, then labour supply may also

increase. Using a standard model of time use and labour supply, it is straightforward to

show that a reduction in travel times has the same economic effect as an increase in an

individual’s lump sum income, and does not change the real wage. It follows that if

leisure is a normal ‘good’, then a reduction in travel times will lead to an increase in

leisure, but labour supply may also increase.

However, in these models the welfare effects of faster broadband speeds do not depend

on the response of labour supply. The labour supply effect of faster broadband speeds

becomes important when there is a wedge between the marginal benefit and marginal

cost of labour (e.g. an income tax). These taxes reduce the compensated supply of

labour, and anything that reverses these disincentive effects (i.e. increases the quantity

of labour supplied) will increase revenue collected from labour income taxation, without

requiring an increase in income tax rates. Hence, any revenue gains are welfare gains.

Similarly, any losses due to reductions in labour supply are pure welfare losses. The

same analytical considerations apply to pure productivity improvements which result in

increased tax revenues. The above analysis suggests that in the presence of distorting

income taxes it may be important to examine the “spending effect” of faster broadband

33 See, for example, Dettling (2013) who finds that access to high-speed broadband services at home has improved the labour force participation of married women.


speeds (see the analysis of the marginal cost of funds in the Appendix 7) since this may

alter the welfare effect of any government project.

3.10.3. Competition/Market Power Effects

A further argument that is often made in the context of faster broadband speeds is that

they may increase competitive forces and reduce market power in some markets.34 This

can happen if transaction costs fall by a sufficiently high amount so that the extent of

the market is effectively enlarged as consumers now find it attractive to purchase from

other firms.

If affected markets are characterised by imperfect competition, then reductions in

transaction costs may bring additional benefits beyond those usually ascribed to falls in

transaction costs in a CBA. For example, suppose are transaction costs in a retail market

served by a single profit maximising monopolist firm. If faster broadband speeds

eliminate these transaction costs, consumer prices will fall. This is a welfare gain.

However, if the reduction in transaction costs opens up the market to a second

competitor, which itself is a monopolist in a different market, then the market

effectively becomes a duopoly. Assuming that there is no collusion between these

duopolists, consumers in both markets will gain further as a result of competition

forcing prices lower.

Since many markets are workably competitive or are already subject to competition

from imported goods, it is unlikely that these additional, second round effects will be

widespread. However, there may be certain industries in which they are important. For

example, in television and video-on-demand markets, faster broadband speeds may

lower transaction costs and intensify competition in the domestic market, as

international firms compete more vigorously against domestic counterparts.

Any effects would depend heavily on assumptions regarding market structure. For

example, if oligopolistic markets are characterised by Bertrand competition rather than

Cournot competition35, then this would have welfare implications. Under Bertrand

34 See, for example, Plum Consulting (2008).

35 In the Cournot model of imperfect competition, firms choose quantities, whilst in the Bertrand model they choose prices. See, for example, Chapter 12 of Mas-Colell, Whinston and Green (1995).


competition, price may already be bid down to levels close to marginal costs, and the

consumer gains from further competition would be limited.

4. CostsFor the purposes of a CBA of various broadband network infrastructure projects,

estimating the quantifiable social costs of any project will require three important

components: direct costs; the cost of capital; and the opportunity costs of taxation

needed to fund the project. Pricing arrangements may also impose social costs that

should ideally be captured in a CBA. This section explores these issues.

4.1. Direct CostsDirect project costs (which are comprised of construction costs and maintenance costs)

could be estimated from existing engineering and construction data, taking into account

evolution of prices in relevant input markets and likely delays given past experience.

Estimating the future costs of different scenarios – which is vital for a CBA – is a more

complex task. A detailed cost model should be developed to investigate the costs of

different policy options (which may vary the speed of rollout, the extent of any network

coverage, the mix of technologies and so on). Ideally, a “bottom-up” cost modelling

approach should be employed for this purpose, using assumptions regarding exchange

areas, services, lines, contention ratios and so on. This task is likely to require highly

specialised technical knowledge regarding the physical engineering and construction

requirements of different project scenarios. Probabilistic costing – which could be used

to produce costs at P10, P50 and P90 levels (percentiles of the probability distribution) -

is becoming widely used in CBAs. If the probability distribution is reasonably

symmetrical, the P50 (i.e. median) cost could be used as the expected value in a CBA,

and the P10 and P90 costs could be used for sensitivity testing.


4.2. The Social Discount Rate

Since a HSBB network will typically take many years to construct and will have high

upfront costs, the choice of discount rate – which is used to compare streams of costs

and benefits over time – is crucial. As discussed earlier, risk is a key issue. There is

considerable uncertainty around both benefits and costs, and along multiple dimensions

(geographical/spatial, intertemporal etc.).

As a general rule, there are two ways of discounting streams of uncertain benefits and

costs:

Use expected values in the numerator, but use a higher risk-adjusted discount

rate in the denominator.

Use certainty equivalent values in the numerator, but risk-free discount rate in

the denominator.

For systematic risk and where the assumptions of the CAPM hold, both approaches are

formally equivalent.36 There are a number of ways of choosing a discount rate37, two of

which are:

Descriptive: Under this approach, the discount rate is the opportunity cost of

capital, so one should use financial market interest rates as a guide.

Prescriptive/normative approach: Under this approach, the discount rate is the

welfare-preserving rate of return on saving. This can be derived using ethical

assumptions regarding the weighting of welfare across time and across

generations.

It is important to note that there is little professional consensus among economists

regarding the appropriate choice of discount rate. Even within these two very different

36 For a demonstration of this result, see Trigeorgis (1996).

37 As noted by Harrison (2010, page 41), a common problem with cost-benefit studies is optimism bias, which is the tendency to underestimate costs and overestimate benefits. Altering the discount rate is a relatively poor way of correcting for such downside risks – they are most appropriately accounted for in the estimated of expected values.


approaches, there is much room for disagreement. The most appropriate way to

proceed in a CBA is to use a range of discount rates, and to conduct sensitivity analysis.

In the present case, given that any government investment may partially or completely

substitute for similar private sector infrastructure investment, the descriptive approach

would seem to be the most appropriate. The discount rate can be computed using

standard techniques, by calculating the project’s weighted average cost of capital

(WACC) using, for example, the capital asset pricing model (CAPM) to determine the

cost of equity. A range of rates should be used and subjected to sensitivity analysis. For

example, one straightforward approach would be to use the three rates recommended

by Infrastructure Australia (4, 7 and 10 percent).

Given the uncertainty around take-up rates and revenue growth, it is appropriate for a

significant risk premium (determined by an appropriately chosen asset beta) to be

added to the risk free rate. Arrow and Lind (1970) argue that if a government project is

small and its returns are uncorrelated with national income, then the social cost of risk

tends to zero as the risk is spread among a sufficiently high number of taxpayers. The

implication is that the correct rate to use for public investment projects is the risk-free

rate. In this case, however, it is highly unlikely that the Arrow-Lind assumptions hold. In

the context of HSBB, any government investment is likely to be relatively large, and its

returns are likely to be positively correlated with national income. In other words, any

public HSBB infrastructure project is likely to have a high level of systematic or non-

diversifiable risk.

below demonstrates the general sensitivity of present values to the choice of discount

rate. The figure plots the present value of $1 that is received in either 10, 15 or 20

years’ time under various discount rates. For example, using a discount rate of 15

percent, $1 worth of benefits that is received in 10 years’ time is worth only $0.25

today, and the same benefit received in 20 years’ time is worth only $0.06 today.

Figure 4.10: The Present Value of $1 Received at Different Points in the Future, for

Different Discount Rates


$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

5 6 7 8 9 10 11 12 13 14 15 16

Pres

ent V

alue

of $

1

Discount Rate (percent)

10 years15 years20 years

The choice of discount rate may obviously have important implications for the

qualitative and quantitative results of a CBA, but may also affect the strategy employed

to estimate future benefits and costs. Choosing a higher discount rate means that long

term predictions (i.e. those extending more than 20 years) regarding future take-up

rates and the benefits from applications, services, products and devices that have not

yet been widely adopted (or have not yet been invented) receive a very low weight –

with a high discount rate, any future benefits received from these end-use products are

simply not worth very much in today’s dollars. On the other hand, if a low discount rate

is used, then benefits received in the future become more valuable in today’s dollars,

and greater accuracy in the estimation of future benefits becomes more important.


4.3. The Timing of Investment and Option Values

4.3.1. Dynamically Efficient Investment

Appendix 6 develops a simple model of the optimal construction of an infrastructure

project over time under conditions of certainty. The main point of that analysis is that

conceptually there is an optimal path of investment in which construction occurs

incrementally – it is almost never optimal to invest all resources immediately. Indeed, it

is straightforward to construct examples in which the optimal investment path is for

investment in capacity to steadily ramp upwards over time, and for most investment to

occur later rather than sooner. The factors that affect the optimal path of investment in

an environment of complete certainty include the discount rate, the depreciation rate,

and the incremental costs and benefits of investment at any point in time. In an

uncertain environment, risk factors will also affect the optimal path.

For the purposes of a CBA of construction of a HSBB network, the main implication is

that the investment paths of some infrastructure projects will more closely resemble the

dynamically efficient path than others, and that the costs of inefficiently timed

investment should ideally be accounted for in a CBA.

4.3.2. Option Values

High speed broadband networks possess features of experience goods: the

characteristics and quality (marginal benefit) of an experience good are uncertain, costly

to determine, and cannot be determined precisely prior to consumption. A common

concern with such goods is that producers will have an incentive to misrepresent the

quality of the good, with consumers (including governments) paying excessively high

prices for goods that, before consumption, are perceived to possess high marginal

benefits but which, after consumption, turn out to have a relatively low marginal value.

Markets have developed a number of mechanisms to deal with the potential

inefficiencies that may be associated with experience goods. For example,

intermediaries may provide specialised verification services, examining the quality of

various goods in exchange for a payment from consumers. Firms may establish


reputational capital as a commitment device, signaling to consumers that if they are

detected “cheating” (selling a low quality experience good for a high price), they will

incur a high cost as this capital is quickly eroded.

Consumers can also take steps to mitigate their exposure to the risks associated with

experience goods by deliberately delaying their consumption (or by limiting

consumption to smaller amounts) until more information about the incremental benefit

of the good becomes available and uncertainty is partially or fully resolved.

Investment in HSBB networks is largely irreversible, with uncertain costs and benefits.

Uncertainty is likely to be only gradually resolved over time, as technology evolves and

end-user applications develop. Construction of a HSBB network therefore involves

purchasing and exercising a series of embedded real options. For example, the decision

to roll out infrastructure in a particular geographic area when demand is unknown

involves exercising a real option. These options have value, and this value should ideally

be accounted for in any CBA.

If consumers are uncertain about future value of applications, they may value the option

of having faster speeds made available even if they do not immediately take up the

service. For a given level of uncertainty about future benefits, the gain to consumers

from possessing this option is higher, the higher their current network usage and

current benefits. However, given that marginal benefits are declining, and given the

likely distribution of preferences for faster speeds, the overall value of this option may

be low.

On the other hand, given the irreversible nature of infrastructure investment and the

uncertainty associated with the development of new and improved technologies, there

may be a benefit to delaying investment. There is an economic tradeoff involved in

directly adopting a “target” technology on the one hand, versus adopting a

technologically inferior but less costly intermediate technology on the other. All else

being equal, an infrastructure project which allows for construction flexibility and keeps

these supply side real options open is more likely to be superior to a project that does

not.


4.4. Taxation

4.4.1. General Considerations

In any CBA it may be important to consider the treatment of goods that are subject to

taxes and subsidies. In particular, if the goods whose demand is significantly affected by

faster broadband speeds are taxed or subsidised, then changes in tax revenue should

also be taken into account in any CBA. In particular, an increase in tax revenue (or

reduction in subsidy payments) induced by changes in demand represents a welfare

gain, whilst a fall in tax revenue (or an increase in subsidy payments) represents a

welfare loss.

For most products these effects will be relatively small and may be safely ignored. In

other cases these tax interaction effects may be important. For example, if an increase

in broadband speeds leads to a significant increase in demand for online retail goods

[some or all of which may not be subject to Australia’s goods and services tax (GST)] and

a shift away from purchases in more traditional “bricks and mortar” retail stores, then

tax revenue may be lower than it otherwise would be, and this would represent a

welfare loss. Similarly, if an increase in broadband speeds leads consumers to reduce

their labour supply (by inducing individuals to undertake more leisure as they spend

more time on the internet or using entertainment applications ), then this would

exacerbate the effect of existing labour market distortions, reduce income tax revenue

and should be counted as a welfare loss.

The basic idea is illustrated in Figure 4.11, where the increase in broadband speed again

increases demand for good A, but reduces demand for good B. In this example, good B

is now assumed to be subject to an existing tax, with revenue returned to consumers in

a lump sum fashion. The reduction in demand for B reduces the amount of revenue

collected by the tax on B (this is the shaded area), and since this reduction in revenue

was not offset anywhere by a reduction in tax rates, it represents a pure welfare loss

which must be added to the sum of the changes in consumer surpluses in each market.

Similar considerations apply to goods whose consumption may be subject to positive or

negative spill overs (i.e. externalities). For example, if an increase in speeds leads to an


increase in demand for goods which are associated with an unpriced (or under-priced)

negative external effect, then the change in demand multiplied by the size of the

marginal externality must be subtracted from the change in consumer surplus in the

relevant market to compute the welfare effect in that market.

An increase in demand for goods which are associated with unpriced positive

externalities (e.g. education) would need to be treated in a similar way. Note, however,

that if such goods are already appropriately taxed or subsidised then there are no

additional welfare effects to consider beyond changes in private consumer surplus.

Thus, for example, if health and education are already subsidised optimally (i.e. to the

point where marginal social benefits equal marginal social costs – an assumption which

would need to be verified), then the fact that more of these goods may be demanded as

a result of faster broadband speeds would have no overall welfare consequences,

beyond the changes in private consumer surpluses that come about as a result of those

changes.

Figure 4.11: Welfare Effects of a Change in Demand When an Existing Good is Taxed

0AP

1Ax

1Bx

1

1

BDAD

Market A Market B

0Bx

APBP

0BP

0

0

0Ax

'BD'AD

ACSBCS

0B BP t

4.4.2. The Marginal Cost of Public Funds

A basic principle of welfare economics is that the direct resource costs of government

spending should be grossed up by the marginal cost of public funds (MCF) – i.e. the costs


of taxation – to determine the full social cost of the project, which is the reduction in

private surplus that occurs when the project goes ahead. The Department of Finance’s

Handbook of Cost-Benefit Analysis states that:38

“The excess burden of taxation means the supply cost of public investment or services is

greater than the actual amount of funds used. Consequently, it is appropriate to make

an upward adjustment to financial costs in cost benefit analysis to ensure the calculated

net present value is unbiased. This is, however, only where there is a significant net cost

to the budget. It excludes cases where costs are fully recovered (such as where there is a

user charge) or the resources are already committed (which is effectively so for cost-

effectiveness analysis and lease-purchase analysis).”

Ignoring the MCF can have deleterious welfare consequences. Consider Figure 4.12

below, which plots the marginal benefits and marginal costs of government spending. In

the example, marginal costs are assumed to be constant.

Figure 4.12: The Marginal Cost of Funds and the Optimal Provision of a Publicly

Provided Good

MB

MC*MCF

MC

Quantity


Welfare Loss if DWL of Taxation is Ignored

G* GOptimal Provision

38 <http://www.finance.gov.au/publications/finance-circulars/2006/docs/Handbook_of_CB_analysis.pdf >.


http://www.finance.gov.au/publications/finance-circulars/2006/docs/Handbook_of_CB_analysis.pdf

The curve is the marginal resource costs MC, grossed up by the costs of

taxation, and this represents the social opportunity cost of government provision. This

curve has a convex shape, as tax rates are raised higher to fund greater expenditure.

The optimal provision here is G*, where marginal benefits equate with marginal

opportunity costs. Ignoring the costs of taxation would result in overprovision of G,

which is a point at which marginal benefits are less than marginal opportunity costs.

Ignoring the costs of taxation leads to the welfare loss triangle indicated in the diagram.

Appendix 5 derives the rule of thumb that is applied in the simplest cases.

A range of estimates of the MCF may be applied in the present case. For example, the

Australia’s Future Tax System (AFTS) Review estimated an MCF of 1.24 for labour

income taxes.39 Ideally the MCF should be one of the items subjected to sensitivity

analysis to determine its effect on the final CBA results.

Although financial payments to third parties are transfers between government and the

private sector and net out in welfare terms, the distortionary costs of the taxes that are

levied to raise those funds should be counted as a welfare cost. Similar considerations

apply to project revenues – they are transfers between the private and public sector,

but in principle they could be used to reduce other taxes and so revenues should be

grossed up by the MCF. In summary, net profits (or losses) should be grossed up by the

MCF.

4.4.3. Taxation and Uniform National Wholesale Access Pricing

Another important aspect of taxation that should be taken into account is the implicit

tax and subsidy arrangement that any uniform national wholesale access pricing may

entail. Imposing a uniform price means that downstream providers (and final retail

consumers) in low cost areas will effectively pay a tax, the revenue from which is used to

subsidise consumers in high cost areas. This implicit tax has a number of important

implications for the welfare analysis of various scenarios.

The basic idea is shown in below, where for simplicity it is assumed that there are two geographically separated markets, A and B. The access provider has different marginal costs in each market, labeled cA and cB. There is a uniform price of P that is charged.

39 Jones (2010) and Robson (2005) survey estimates of the MCF.


Consumption in each market is . This arrangement leads to welfare losses in each market, with the welfare effects increasing non-linearly with the size of the implicit tax.40

Note that even though there may be a case for the firm setting price above marginal

cost in market A in order to recover its fixed costs, the prices as drawn in this example

cannot be second best efficient. Prices could be reduced in market A and increased in

market B so as to hold profits constant and reduce the aggregate welfare loss. Indeed,

the standard Ramsey pricing rule applies to such a situation, and states that prices

should be set above marginal costs in each market so that there is an equal percentage

reduction in each market below the first best consumption levels . In this case,

such a second best optimum would necessitate higher prices in market B, and lower

prices in market A (even though market A has a relatively low elasticity of demand at the

first best consumption point ).

40 It is important to note that uniform pricing is also likely to have dynamic deadweight losses as well, by influencing technology choices and distorting the mix of technology that is adopted in urban and regional areas.


Figure 4.13: Cross-Subsidies as an Implicit Tax-Subsidy Scheme

Ac

1Ax

1Bx

1 1

BDAMB

Market A Market B

0Bx

AP BP

0

0

0Ax

Bc

P P

4.5. Non-Quantifiable Benefits and Costs

As discussed earlier, ideally a CBA should place dollar values on all sources of costs and

benefits. However, there may be benefits and costs which are difficult to estimate

accurately, or which are simply non-quantifiable. For example, consumers and

producers may (due to, for example, a lack of information) systematically underestimate

(or overestimate) the likely impact that faster broadband speeds may have on future

innovations and the value of new applications, services and products (including, for

example, e-health and e-education applications). If these systematic biases are present

across a sufficient number of consumers and producers, then estimates of private

willingness to pay which rely on information provided by these groups may not correctly

and/or fully reflect relevant benefits. Other benefits – such as the benefit from being

able to access the “knowledge commons” of the global Internet (or, more relevantly for

policy, the effects of faster speeds on these benefits) – may be difficult or impossible to

quantify. Similarly, there may be significant non-quantifiable social costs associated

with broader network coverage and faster speeds, including issues related to privacy,

data security, national defence and security, intellectual property protection, net


neutrality, cyber-crime and freedom of speech. These are clearly important policy

issues in their own right, and the extent to which they are affected by various

investment options deserves to be discussed and explored qualitatively in a CBA

5. Conclusion and Recommendation for Overall CBA Strategy

This paper has developed an analytical framework to assist the panel of experts in its

development of a CBA of public infrastructure investment in HSBB networks. The paper

has provided some “broadband-specific” conceptual guidance for a CBA by exploring the

main sources of the potential economic impacts of access to faster broadband speeds,

as well as providing guidance on how to estimate these impacts.

The paper has demonstrated that there are a number of significant challenges that need

to be overcome when conducting a CBA of policy options regarding public investment in

HSBB networks. The main challenges are the specification of the baseline scenario and

the significant amount of uncertainty surrounding benefits, as well as the estimation of

benefits.

In practice a range of theoretical assumptions and empirical compromises will need to

be made. The key to developing a robust CBA will be to test the sensitivity of the results

to these assumptions and compromises, in order to clearly demonstrate to decision

makers how they affect the CBA’s final results.

Given that the ultimate purpose of a CBA is to inform policy decisions, the most

straightforward way to proceed would be begin with a (relatively) simple partial

equilibrium analysis of the effects of various policy options on network coverage, speed

and incremental net benefits. Under this approach, the analysis would begin with the

simplest model that is fit for purpose: social benefits would be assumed to be fully

captured by private willingness to pay, and estimates of consumer valuation could be

compared with direct project costs. Factors such as externalities and other effects

discussed in this paper could be temporarily put to one side.

Once a partial equilibrium analysis is completed, some of the more conceptually difficult

issues explored in this paper could be dealt with. In the first instance, these factors


could be dealt with qualitatively, by exploring the extent to which a more complicated,

general equilibrium analysis would increase the economic value of various policy

options, and whether such effects are likely to vary greatly across options. For example,

it may be the case that the presence of network externalities would increase the net

benefits of all policies by a similar magnitude, leaving unchanged the overall ranking of

policies that emerged from a simple partial equilibrium analysis. Alternatively, if a

simple partial equilibrium analysis suggests that the net benefits of certain policies are

likely to be negative, a qualitative analysis could be used to show how positive the

benefits from other sources would need to be in order to reverse the results of the

simpler modelling exercise.


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Indexes: Special Application to Information Technology Products, Paris: OECD Publishing.

Varian, H., Farell, J. and Shapiro, C. (2004) The Economics of Information Technology: An

Introduction, London: Cambridge University Press.

Willig, R. (1978) “Incremental Consumer’s Surplus and Hedonic Price Adjustment”,

Journal of Economic Theory, 17: 227–253.


Appendix 1. The Indirect Demand for Faster Broadband Speeds

This appendix considers some of the analytical foundations of the value of faster

broadband speeds. Consider Willig’s (1978) approach to valuing changes in the

attributes of goods.41 Let be a consumer’s indirect utility when prices of goods

are , income is y and broadband speed is s. That is:

In this formulation, faster broadband speeds are assumed to affect consumer decisions

by altering the marginal utility from consuming different goods and services. The effect

of faster speeds is isolated by deliberately assuming that prices and incomes are held

fixed at current levels. The welfare gain from being able to access a network with a

greater speed of (compared with the current network speed of ) is then simply

.

At the consumer’s optimum, using the envelope theorem at the margin, a small or

incremental change in speeds gives a change in consumer welfare of:

and so:

It is possible to express marginal changes more conveniently by noting that:

where is the marginal utility of income, is the current price of good i, and is the

price for which (so that changes in speed do not affect demand if prices exceed

41 See also Johansson (1987), Chapter 6.


this level), and where the last equality uses Roy’s identity42 (which relates the indirect

utility function to the ordinary demand curve for the good).

As a technical aside, the expression in can be derived more precisely by replacing

ordinary demand curves with their compensated counterparts. If is the

compensated demand curve for good i at the initial level of utility, then the welfare

effect of a change in Internet speeds can be measured by the amount of money that,

given the new speeds, could be taken away from the consumer to restore them to their

initial utility level, which is .

Alternatively, the welfare effect could be measured by the amount of money that, given

current speeds, the consumer would be willing to pay for a level of wellbeing that they

would have received with faster speeds. This is . In

the absence of income effects, both of these expressions are equivalent to .

42 Roy’s identity links changes in consumer welfare (brought about by price changes) to the ordinary

demand for the good. Specifically, it states that - the change in a consumer’s utility with

respect to a small change in prices is equal to the negative of the marginal utility of income, multiplied by the level of ordinary demand for the good. If the marginal utility of income is constant, then the area to the left of an ordinary demand curve is an exact measure of welfare change. See, for example, Chapter 3 of Mas-Collell, Whinston and Green (1995)


Appendix 2. The Simple Welfare Economics of the Gains from Productivity

Improvements

This appendix develops a very simple high level model to illustrate the static economic

gains from an economy-wide total factor productivity (TFP) improvement and the effect

on labour supply and demand. Suppose that the aggregate production function is

, where L is labour input, A is a total factor productivity parameter, and F() is

a strictly increasing, strictly concave production function. Utility is a function of

consumption and leisure, so . All output is consumed. The economy faces a

time constraint of .

Substituting these constraints into the utility function gives:

By the envelope theorem:

or:

This states that, in a static setting, the marginal welfare gain from an improvement in

productivity is equal to the marginal utility of consumption, multiplied by the current

level of output, multiplied by the percentage increase in productivity. Note that this

expression, which quantifies the benefit from an improvement in productivity, does not

depend on the number of jobs that are created as a result of the productivity shock i.e.

whether the improvement in productivity increases or decreases the quantity of labour

employed. Indeed, depending on the relative size of substitution and income effects,

the equilibrium quantity of labour could fall. In this case, the expression in can still be

used to quantify the benefits from an increase in TFP.


Appendix 3. Welfare Analysis in Discrete Choice Models

The approach outlined in section 3.6.2 can be used to directly estimate willingness to

pay for faster broadband speeds. A standard approach in the literature is to assume

that the random component of indirect utility is additive, so that:

The probability that alternative j is chosen is then simply:

This probability depends on the assumed distribution of the random variable .

Since this is a random utility model, it is necessary to work with expected values, that is,

we need to find:

and then adjust these for changes in characteristics. As a general rule, it is not possible

to easily compute numerical solutions for this expression. To numerically estimate the

willingness to pay for different package characteristics (such as speed), it is necessary to

make choices about the distribution of the random error terms and the functional form

of the indirect utility function.

For example, a multinomial logit model assumes that the disturbance term follows a

Gumbel (or type 1 extreme value distribution):

Under this assumption, the differences follow a logistic distribution:

If a linear function for the observable characteristics of the utility function is assumed,

then:


Then the probability that alternative j is chosen is:

For the extreme value distribution, it is:

where C is an undetermined constant.

The compensating variation of the change in package characteristics from to is

defined implicitly by:

For the linear functional form, it is:

so that the actual CV is:


Appendix 4. The Dynamic Efficiency of S-Shaped Product Diffusion Curves

In the product diffusion literature there is often little connection between “S-shaped”

take-up paths and the standard economic theory of consumption and welfare. This

appendix examines the conditions under which such a take-up path is economically

efficient. The implication of the analysis is that by making an assumption about the path

of take-up or adoption, a CBA is also implicitly making an assumption about the

evolution of consumption benefits over time. Assumptions about one cannot be made

independently of the other, and they should be consistent with each other.

The approach is a simple consumption/wealth accumulation model that is standard in

the literature. Let c be the take-up rate, where 0<c<1. Let w be wealth. Let be the

social rate of time preference, and let r be the interest rate on wealth accumulation.

Consider the problem:

subject to:

and:

The utility function u(c) can be interpreted as benefits of take-up, or a social planner’s

objective function, i.e. a social welfare function over aggregate consumption (the take-

up rate). The purpose is to seek to find benefit or social welfare functions for which the

following patterns of consumption are optimal:

Where . Note that if then the Gompertz function applies:


It is possible to use standard techniques (i.e. Pontryagin’s maximum principle) to solve

this problem. The current value Hamiltonian is:

where is the current value costate variable. The necessary first order conditions are:

From it is:

whilst gives:

Hence:

or:

where:

is the elasticity of the marginal utility of consumption. This is a standard result in the

literature. To match with apply:


Hence if:

With then the generalised logistic function in , will be optimal.

For the specialised Gompertz case:

This gives:

where is an arbitrary constant and is a negative number. This has therefore

established that the Gompertz product diffusion curve is an optimal consumption path if

(and only if) the aggregate benefits of take-up obey .


Appendix 5. A Simple Model of Network Effects

Consider a simple model with a continuum of consumers. Their individual valuations

from accessing broadband are . The formula below allows this individual valuation

to depend on network speed.

Assume that there is a network externality present of where I is the number of

users on the network, and, in the case of positive direct marginal network

effects, for all I.

Total welfare is the sum of valuations, less cost:

where for simplicity it is assumed that marginal costs of network capacity are constant

and that the scaling effect of network externality is the same for all users, which means

that users with a higher valuation gain a higher absolute level of utility, the more users

there are on the network.

Efficiency requires that:

The first term is the effect on the marginal consumer’s own welfare when he joins the

network. The second term is the direct marginal network externality – it is the change

in the size of the overall network effect when the marginal consumer joins multiplied by

the effect of this on all existing inframarginal users.

Clearly, if network externalities in this environment are ignored and only the individual

WTP component is measured, then problems would arise for a CBA. Total welfare from

the network would be incorrectly measured as:

And the CBA would advocate building additional network capacity as long as:


Since the left hand side of is less than the left hand side of when , then a CBA

which ignored network externalities in such an environment could give incorrect results.

However, there are two mitigating factors. First, if there are network effects present

and individuals are asked to report their willingness to pay, then they will report

, where I is the size of the network that they expect, even if that is not explicitly

stated. This could be larger or smaller than the efficient network size. Hence, the

extent of the error may not be as large as would be implied by the earlier discussion.

Second, discrete choice econometric methods could be used to estimate the size of

network effects, and these could then be incorporated into the CBA.

Now consider a market environment. Suppose that there is a price of p that is charged

to access the network. To compute the equilibrium network size, first compute the

demand curve. Suppose that I users are on the network. Then the marginal user is

indifferent between joining and not joining:

This condition defines the demand curve for the good.43 Note that there may be

multiple equilibria depending on the strength of the network effect. In a perfectly

competitive market, users will join up until the point where marginal valuation equals

marginal cost:

Since it is assumed that , it is clear that, in a competitive market, the size of

the network will be inefficiently small.

Note, however, that this result depends on a number of assumptions. In particular, it

assumes that for all I. By way of contrast, suppose that at the optimum,

(i.e. there are negative marginal network effects – or marginal congestion

effects – at the optimum). Then the second term in is negative, and in a competitive

market the size of the network could be too large.

43 See, for example, Varian (2010), Chapter 35.


Maximum Network Speed

To examine the effect of a uniform increase in maximum network speeds in this model,

again assume that there is a direct network externality present, but that valuations

depend on the maximum available speed of access, labelled s. Assume that the

marginal cost of building network capacity also depends positively on s. Finally, assume

that the maximum is the same for all individuals on the network.

Total welfare is now:

Suppose that the network capacity has been optimally chosen. Then, by the envelope

theorem and Leibniz’s rule, it is socially beneficial to increase speed up until the point

where:

On the other hand, in a competitive market environment, increases in maximum speed

will be provided as long as the marginal consumer is willing to pay for them. Hence we

must have:

The question of whether the market will provide speeds that are too fast or too slow in

the presence of network externalities depends on a comparison of and . That is, market

maximum speeds will be inefficiently slow if:

If the marginal network externality is everywhere positive, then: . The

question is therefore whether:


This involves a comparison of the marginal willingness to pay for higher maximum

speeds of the marginal consumer in a competitive market, versus the average marginal

willingness to pay of the entire population assuming that an efficient network capacity.

It is not at all obvious that the right hand side of should be larger than the left hand

side.

Moreover, if the network is subject to congestion effects, matters are even less clear. If

there are too many network users in a market setting and the network becomes

congested, then it is a second best environment, and firms may try to offset some of

these congestion effects and compete for customers by offering inefficiently fast

maximum download speeds.


Appendix 6. The Dynamic Efficiency of Investment

Consider the following simple model of investment. There is an infrastructure project

which builds up a stock of capital of over time, and yields a flow of benefits of

at each instant, with . Capital is built up via investment,

but depreciates at a rate . Adding to the capital stock has a cost of , where I is

the amount of investment. Assume that and . Future net benefits

are discounted at the rate of r.

The purpose is to seek the path of investment that maximises the present value of the

flow of net benefits. In other words, to solve:

subject to:

and:

This is an optimal control problem which can be solved and analysed using standard

techniques.

The current value Hamiltonian is:

where is the current value of the co-state variable or the shadow price of capital. The

first order necessary conditions for this problem are:44

44 The Hessian of the Hamiltonian is jointly concave in I and K, and so the first order conditions are also sufficient.


Expression states that investment in each period should occur up to the point where

the marginal cost of investment equals the shadow price of capital. Expression states

that the shadow price of capital changes over time according to:

These expressions can be used to qualitatively examine the optimal path of investment

using phase diagram analysis. Using such an approach, it is straightforward to

demonstrate there are instances where it is optimal for investment to begin at a low

level and increase over the life of the project.


Appendix 7. The Costs of Taxation

This section derives a commonly used rule for accounting for the costs of taxation in the

supply of publicly provided goods. Let be the direct resource cost of supplying G,

which may be a private or public good supplied by the government. The government’s

budget is assumed to be balanced, so that:

where R is tax revenue and is the ordinary demand for good i, and ti is the tax rate on

good i.

The government chooses the level of G and the vector of tax rates t in order to

maximise indirect utility subject to . The Lagrangean is:

The first order necessary conditions are:

and:

for each j = 1,…,n.

Dividing by yields:


Finally, dividing both sides by the marginal utility of income and applying Roy’s identity:

The left hand side is the social marginal benefit of an additional unit of the government

supplied good, expressed in dollar terms. The right hand side can be decomposed as

follows. Recall that the marginal excess burden per dollar of revenue is:

Hence, the first term on the right hand side, , is one plus the absolute value

of the marginal excess burden, or the marginal cost of public funds of MCF for tax ti. The

expression in implies that taxes should be adjusted until the MCFs for each tax are

equalised.

The term inside the brackets on the right hand side of is therefore the marginal cost of

G, minus the effect of higher G on revenue from goods that are already taxed. This

needs to be taken into account because as G increases, consumption of goods that are

complementary to G will rise, and to the extent that these are taxed this will raise

revenue that the government would not have otherwise received.

On the other hand, consumption of goods that are substitutes for G will fall, and this will

reduce tax revenue. Hence the term (which is known as the “spending

effect”), may be positive or negative. If a project reduces labour supply, then the

spending effect is negative, which means that all else being equal, benefits must be

higher in order to justify the project. The opposite conclusion applies if the project

increases labour supply.


Ignoring this spending effect, the revised Samuelson (1954) rule is to provide G up to the

point where:

If taxes are not distortionary, then and the conventional Samuelson (1954)

rule applies:

For discrete projects or policies, a discrete version of can be used. Suppose that there is

no spending effect. Consider a government spending proposal which yields social

incremental benefits of B for each additional unit of G that is provided.

Suppose that each unit of the project has a price of P, which is equal to its direct

resource cost. Hence the budgetary cost or expenditure is P×G.

The project must be funded by distortionary taxation. Let the tax rate be t. As far as the

private sector is concerned, the cost of this taxation is the foregone gains from trade;

that is, the lost producer and consumer surplus. This in turn is equal to the sum of tax

revenue plus the deadweight loss of the tax. The change in these costs (i.e. the marginal

cost) is therefore R+DWL.

Now suppose that taxes must increase by a very small amount in order to fund an

additional unit of G. Government tax revenue increases by R. This allows additional

amount of the public good of G = R/P. This additional amount yields benefits of B

×G = B × R/P.

Hence the additional unit of G should be provided if the incremental benefits B ×G

exceed the incremental costs:

or:


An additional dollar of government spending is justified on efficiency grounds if the

marginal benefit of that spending exceeds the price or direct cost, grossed up by the

marginal cost of public funds, which depends on the deadweight costs of taxation. The

term in is the marginal deadweight loss per dollar of revenue. The MCF is

equal to one plus the marginal deadweight loss per dollar of revenue.


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