The content on this page and other DBCDE document archive pages is provided to assist research and may contain references to activities or policies that have no current application. See the full archive disclaimer.

Convergence Review

A comprehensive analysis of the issues related to the convergence of technologies and markets in the telecommunications, information technology, broadcasting and media industries, and the wider economy, over the next five to ten years.

CONVERGENCE REVIEW ISSUES PAPER

1.0 INTRODUCTION

Governments all over the world are grappling with the issues raised by convergence between previously separate industries. The traditional barriers between industry sectors such as film, music, publishing, broadcast television and radio, telecommunications, computing, and services industries such as education and health are being eroded or restructured, and new industry boundaries are emerging.

The aim of this chapter is to explain why convergence has become an issue for governments. The answer is that government intervention (or the lack of it) in the convergence process will affect national outcomes in key areas like investment, job creation, international competitiveness, social and cultural outcomes, and regional development. Without a clear understanding of the links between national outcomes, government interventions, and structural change, there is no way that the government can address convergence coherently.

1.1 Convergence, industry structure and the scope of this review

There is no generally accepted definition of convergence. It can refer to technological change, commercial mergers and acquisitions, or the emergence of new service types. Convergence issues encompass structural issues like the management of access markets, social issues like the availability of new services, and legal issues like copyright definition in electronic service markets.

This paper addresses convergence from the perspective of industry structure. This is because assumptions about industry structure underpin the current policy framework. If the structure changes, then the policy framework will fail.

The convergence agenda is not the same as the information economy agenda. The information economy agenda contains a range of important issues such as the protection of digital copyright, the promotion of community awareness and participation in the information society, and the promotion of consumer confidence in digital transactions. However, these are not directly related to structural convergence and are not the focus of this Review.

Nor is convergence solely or principally about the media industries. The media industries have a special role because of their social and cultural significance, but they are subject to the same basic technological, structural and policy challenges as the rest of the services sector.

For the purposes of this review, convergence is defined as services sector restructuring enabled by digitalisation. This definition has been adopted because it captures the main features of convergence that are relevant to this Review:

• First, it recognises that the scope of convergence is the entire services sector, not just telecommunications and broadcasting. The use of digital network technology already extends into new health, education, entertainment, print and financial services which use electronic text, still pictures, and transactions.
• Second, it emphasises the structural dimension of convergence, which is the focus of this Review. Structural convergence has been under way for several decades and may yet have several decades to run. For example, the same forces which are enabling and driving convergence are also behind the restructuring of Australia's telecommunications industry.
• Finally, convergence is enabled by technological change. At the same time, it is driven by commercial forces. As technological change erodes traditional economies of scale and scope, industry players are seeking commercial gains by restructuring their operations to exploit new economies of scale and scope.

'Structural convergence' simply means the structural impact of services sector digitalisation. The 'convergence industries' are simply industries where structural convergence will have a significant impact - the infrastructure-based industries which provide information and transaction-based services. These industries are prominent in Australia's industrial landscape: telecommunications, retail, education, health, financial services, and the broadcasting and the film and music industries. The analysis of convergence must start with them.

1.2 Two structural paradigms in transition

Two service sector business systems are currently in contention, each with its own preferred industry structures and business models.

The first system is exemplified by the traditional industries of telephony, radio and television. It is based on:

• analog, single-service network technologies;
• vertically and horizontally integrated corporate structures;
• business models based on mass production, with limited or non-existent service flexibility; and
• domestic market scope.

The suppliers' control of service design and delivery has made it relatively easy for regulators to control service and industry outcomes, because these requirements could be imposed directly onto domestic infrastructure owners.

The Internet and the networked applications that are deployed across it exemplify the second system. It is based on:

• digital, programmable network technologies which support multiple applications;
• vertical structural separation between the services (which users see) and the underlying delivery networks, and new competition in industries which were previously monopolies or oligopolies;
• business models based on mass customisation, with close user involvement in service definition, and significant flexibility and service innovation; and
• international market scope.

Service and delivery activities are becoming increasingly fragmented, dispersed and internationalised as these changes occur. Government intervention in these activities is becoming progressively more difficult because the current policy framework relies on traditional assumptions about industry structure and market scope which are increasingly irrelevant.

The service sector is in transition between these paradigms, and this transition will be a costly and complex process. Different countries and different industries are proceeding at different paces, creating commercial and regulatory tensions in both international and domestic service markets. In many ways, it is the management of the transition, rather than the management of convergence per se, which is the greatest challenge for both industry participants and governments.

1.3 Convergence policy issues

The scale and nature of convergence raises many issues for government, and will profoundly affect the government's capacity to achieve the economic, social, cultural, and industry development objectives set out in current policy:

• Convergence will be pervasive, extending the services sector and reaching from there into the other industries which use services as inputs. It will have a significant impact on national economic performance, our competitiveness in international markets, and our capacity to attract inbound investment.
• Convergence will undermine traditional industry arrangements and business models. There will be important new avenues for economic growth and development, and significant destruction of the value of existing businesses. Government policy settings will strongly affect industry's ability to manage the transition successfully.
• Convergence will have significant impact on our labour markets and on demand for skills. The services sector is the primary engine of employment growth in all developed economies including Australia, and convergence will affect the sector's capacity to generate new high-value jobs in the future.
• Convergence means increased trade exposure in industries where natural barriers to competition have previously afforded a level of protection for both large and small firms, and raises new issues about Australia's positioning in international services markets.
• Convergence raises new opportunities and threats for Australia's regions. Convergence could be either a centralising or a decentralising force, but it will certainly be a major factor in the competitiveness of the regions and their capacity to attract service-related investment and economic activity.

Government intervention matters. It is an important determinant of industry structure and performance, and will affect industry's ability to adapt to the new environment. A regulatory regime that imposes structural rigidness will prevent adaptation, undermine our structural competitiveness in domestic and international markets for networked services, and deny Australians the benefits of new technology. Alternatively, a policy framework, which addresses convergence developments, will enhance the ability of government, industry and consumers to realise the benefits of change.

1.4 The fundamental issue: new environment, new assumptions

There are many areas where convergence raises questions about the current policy objectives and implementation. A few examples include:

• how to facilitate innovative and competitive networked service industries, including content based industries, in domestic and international markets;
• whether and how broadcasting infrastructure should be subject to the same economic regulation as telecommunications and computing networks;
• how to ensure that Australian content and diversity can be achieved within new industry structures and alliances, new international markets, and new business models;
• how to provide minimum guaranteed levels of access to networked services in a multi-service and multi-infrastructure environment; and
• how the regulatory institutions might be structured to better serve the government's policy objectives.

The fundamental issue addressed by this review is:

• How must the government's policy objectives and intervention strategies be adapted to fit a convergence industry environment?

National outcomes sought by the government do not change with technology, and this review takes these outcomes as given. The emergence of a new industry environment raises two kinds of issues for government policy makers.

The first kind of issue is about the relevance of government intervention in a new industry context. National outcomes such as the promotion of industry development, economic efficiency or Australian culture will always be relevant. Subsidiary or instrumental policy objectives such as the promotion of competition, or local sourcing requirements for carrier equipment, or local content rules for broadcasting, may not have the same relevance or meaning in convergence industry settings. These policy objectives may need to be reinterpreted as the external environment changes.

The second kind of issue is about the effectiveness of government intervention. If it is agreed that government should pursue certain outcomes, what kinds of intervention will be available if structural change erodes traditional mechanisms of intervention? This raises issues about new implementation strategies that will be needed to deliver outcomes.

1.5 The structure of this paper

This paper is in three principal parts. The first part deals with the structural changes arising from convergence. The second part deals with the regulatory consequences of these changes, particularly the way that convergence is affecting the scope and the effectiveness of existing policy objectives and interventions. The third part draws out the policy implications, and presents some explicit issues and questions designed to elicit comment.

The first part begins with an analysis of how changes in technology are affecting economies of scale and scope in the services sector. These shifts in economies of scale and scope are shifting the sources of economic value and the centres of economic power in the services sector, and these changes will flow through into new industry structures and business models. The objective of this discussion is to determine the most important differences between pre-convergence and post-convergence industries, and explain in broad terms what this means for industry participants.

The second part is an analysis of Australia's current policy framework from a structural perspective. Two separate approaches are taken:

• The first is a 'top-down' discussion of the impact of structural convergence on the government's overall economic, social and industry development objectives. The key issue is how to reinterpret these objectives in a new industry structure, particularly a structure where service provision is no longer tied to infrastructure ownership, and where service markets extend beyond our national borders.
• The second approach is focussed on the impact of convergence on the current policy implementation strategies. The key issue is how convergence will undermine the structural assumptions which underpin those strategies, and what implications this has for the scope and effectiveness of the current policy framework for electronic networks.

The third part is a discussion of the implications of structural convergence and the current policy framework for two major sectors: the telecommunications and information services sector, and the media and content sector.

1.6 Issues for comment

A range of issues and questions are presented in those discussions, but submitters may ignore any of these, and may also address any related issues or questions that they think should be raised. The particular questions and issues raised in this paper are summarised in the following points.

3.1 National outcomes and the relevance of policy objectives

Does the government currently pursue any other objectives, apart from the ones set out in this paper? Are these economic, social and industry development objectives more relevant or less relevant in a convergent environment? Are there new policy objectives that should be adopted to meet new challenges?

4.2 The telecommunications and information services industries

Is there a strong relationship between government intervention and industry structure, or is industry structure primarily driven by technological and commercial factors? Should the government aim to determine industry structure pro-actively or should the government merely facilitate structural change when the direction of change is already apparent?

Can domestic intervention in market structure and conduct be effective in an international connectivity environment? Will the primary driver of market structure and conduct be domestic policy intervention, or international technology and commercial factors? How much scope is there for national approaches to structural policies in the convergence industries?

What is the appropriate scope of the interconnection and access regime for digital networks? Should it extend beyond telecommunications networks to include computer

networks and digital broadcasting and cable networks? If not, what factors should determine the boundaries of an interconnection regime? When and where is such a regime needed?

Are there any benefits in preserving the joint licensing of applications and services activities and infrastructure and connectivity activities (e.g. in the broadcasting sector)? Or should these two types of activity be licensed separately across the services sector? What would be the implications for the division of responsibility between different regulators?

Should the telecommunications access regime for content services be extended to include all applications, content-based or not? Or will technological and commercial realities ensure that third-party applications providers have access to digital connectivity anyway?

Will international commercial processes drive technical standards? Are there ways that governments can influence international standards processes, or is Australia a 'standards-taker' only?

Is there a role for government in the area of interoperability between applications? Or is this a commercial matter best left to the applications industries? Are there ways the government can facilitate commercial solutions to these issues? What are the implications for the users of services?

Do current domestic policies address the economic power arising from intangible assets such as branding and proprietary standards as effectively as they address issues arising from physical assets? What are the limits of government's ability to influence outcomes in this area? What are the implications for competition in convergence markets?

Are the current allocation processes for scarce resources such as spectrum and electronic addresses effective in international markets? If not, are multilateral or commercial alternatives available?

Do the efforts of service providers to build up diversified service suites, by acquisition or through strategic alliances, raise any significant competition issues? Does the 'lock-in' of users and customers to particular service providers raise any significant competition issues? Are these issues significantly different from competition issues arising from bundling or marketing in other industries?

Will the growing diversity of demand undermine the relevance of 'one size fits all' interventions such as the Universal Service Obligation? Is the universal provision of a standardised telecommunications service the correct objective in a convergence environment?

Can more diverse demands be met through the current industry and regulatory framework, or will alternative implementation mechanisms be needed? What role might new sources of connectivity such as digital datacasting play in meeting these new objectives?

Are there non-regulatory mechanisms, including commercial mechanisms, which could be used by the government to promote access to connectivity in otherwise marginal consumer markets and user communities?

Should the government's long term role be the facilitation of the delivery of applications and services? Or should the government's focus be on the provision of connectivity, bandwidth and the associated infrastructure?

What are the implications of borderless delivery of services for the regulation of service delivery? Can the consumer safeguards and accreditation schemes already established in the education, health, retail, and other service industries be readily transferred to the electronic domain? How can these safeguards and schemes be enforced in international markets? Are commercial solutions to consumer confidence issues adequate to address consumer issues? If not, what should be the balance between government intervention and commercial incentives to preserve market reputation and the value of the brand?

Are current market development and innovation support schemes relevant to convergence industry structures and priorities? Are separate industry development policies for application, connectivity and infrastructure industries appropriate, or are there linkages which require concerted development policies? What are the different industry development priorities of the applications, connectivity and infrastructure industries?

What implications does the growing importance of intangible assets such as skills, trusted brands and proprietary standards have for Australia's international competitiveness? Do current policy settings adequately address the new importance of these assets?

What scope is there for the government to raise the level of international connectivity hubbing in Australia? Are there ways that government can indirectly attract infrastructure and connectivity investment by attracting key applications activities such as electronic commerce and content service provision for the Asian region?

Can Australian user communities be leveraged to help generate the required critical mass of activity, investment and innovation needed to ensure international competitiveness? Can government facilitate this process and if so, how? What relevance does this have to economic, industry and social development in regional Australia?

4.3 The media and content industries

Will one service delivery model eventually dominate the media, or is there scope for

different models to co-exist? Will supply-side issues, such as securing distribution channels and sources of content, mean that vertical integration will persist, at least on some areas? Or will the Internet service model prevail?

Should service and infrastructure licensing be separated? How does this depend on the service delivery model that prevails?

If service and infrastructure licensing were separated, could spectrum for broadcasting services be allocated in the same way as other spectrum? Or are there still social issues that should be accommodated in the allocation of spectrum for broadcasting services?

What are the implications for the role of the broadcasting regulator in spectrum allocation and technical regulation?

Will the emergence of international connectivity and infrastructure markets lead to the internationalisation of content-based services markets? Or will demand for local and national relevance mean that content-based service provision will ultimately remain a domestic industry?

What is the impact of the erosion of market boundaries on the current broadcasting licence regime? Are geographical licensing and audience reach rules sustainable if service delivery is no longer tied to terrestrial infrastructures?

Will broadcasting outlets continue to focus on mass audiences, or will audiences continue to fragment over the longer term? Would a more fragmented domestic audience help or hinder the achievement of social objectives such as the promotion of Australian content and media plurality?

How can the cultural and social significance of content-based services be measured in
a multi-channel convergence environment where service provision is no longer linked to infrastructure and connectivity provision? Will channel scarcity, and ownership of infrastructure continue to be the principal source of cultural and social significance, or
will other factors be more important?

How can other dimensions of plurality, such as localism and community access, be accommodated in a convergence environment? Would user communities play a stronger role in a more fragmented media industry?

What is the role of national and community media in extending media plurality and Australian identity in a convergence environment?

Could output requirements like Australian content rules and community standards be enforced in an environment where delivery infrastructures are international, and content and service provision are structurally separated from connectivity and infrastructure provision?

If a more fragmented content service industry emerges in a convergence environment, which 'community' standards should apply: the standards of the general community, or the standards of the target audience? Can the application of these two standards be reconciled, and if so how?

What scope is there for effective non-regulatory interventions to address community standards issues, especially indirect measures which empower individuals, families or communities? Are these measures likely to grow in importance? What is the scope for international cooperation on community standards regulation?

4.4 Regulatory transition management

What particular factors will determine the pace of structural convergence in your industry?

What other factors determine the pace of structural convergence apart from technology change and policy stances?

What other issues are raised by regulatory transition? Are there general lessons from past regulatory transitions (e.g. in the telecommunications or financial services industries) which should apply to the transition to convergence policy approaches?

4.5 Regulatory institutions and enforcement

On what basis should regulators be structured in a convergence environment? Should industry-specific regulators be restructured along economic and socio-cultural lines?

Or should regulators be restructured to concentrate on infrastructure/connectivity and applications/service industries separately? What are the implications for the current responsibilities of the regulators?

Does it make sense for some activities (e.g. spectrum management) to continue to be split between different regulators on industry specific lines?

Where will economic, socio-cultural and industry development objectives overlap and require coordination?

How should the respective responsibilities of Commonwealth and State Governments for digital services policies be determined?

2.0 TECHNOLOGY, CHANGE AND STRUCTURAL CONVERGENCE

In this chapter, we examine the structural differences between the traditional and the convergence services industries. New types of markets for services are emerging, and the geographical scope of those service markets is changing. The structural context of the services sector is now an international context, and international factors will strongly affect Australia's competitiveness in international services markets.

The questions addressed in this chapter are:

• How is technology related to traditional services industry structures and business models, and the traditional sources of economic value and centres of economic power?
• How are changes to technology affecting industry structure and business models, and shifting the sources of economic value and centres of economic power?
• Which industries are likely to bear the brunt of these changes?
• What are the key convergence changes that should be expected in these industries?

2.1 Technology and industry structure

Any discussion of convergence must begin with a discussion about technology. This is because technology is the primary supply-side constraint on commercial action and policy intervention. Business and policy strategies are always designed to exploit a technology's underlying capabilities. It is impossible to understand how new technology is undermining those strategies unless the relationship between technology, traditional industry structures, and the policy framework is understood.

The political economy of these convergence industries will principally depend on two factors:

• Who creates economic value? What kinds of activities and collaborations create the economies of scale and scope which are the source of economic value-added in a convergence environment?
• Who captures economic value? How will changes to market, industry and regulatory structures shift the centres of economic power throughout the convergence sector?

Technology is the most important determinant of these factors, because technology and the associated business processes are the principal determinant of the sources of value-added and the centres of market power. Major shifts in the underlying technology of an industry are accompanied by major shifts in these sources and centres, and a redistribution of the benefits of economic activity. These changes affect different industries in different ways.

There is a close relationship between economic value, economic power and industry structure. Industry participants structure their operations in order to internalise the activities that generate value and to occupy the industry positions that confer economic power. As the sources and centres shift, industry structure will also shift as industry participants restructure their operations in order to capture new commercial opportunities.

Creating and capturing economic value

Economies of scale and scope are important sources of economic value. They reflect the efficiencies that are available through the exploitation of a particular technology.

Economies of scale exist when a bigger business operation is more efficient than a smaller one. There have always been significant economies of scale in network provision. These economies of scale still exist, although they are growing weaker with technological change. Mass marketing can also generate economies of scale in service industries. If economies of scale in an activity are strong, the result is often horizontal integration and a monopoly or oligopoly industry structure.

Economies of scope exist when two different businesses can be run more efficiently together than they can be run separately. If these two activities are vertically related, the result is often vertical integration. If these two activities are both upstream or downstream of a third activity, the result is often the horizontal and vertical integration of all three. There have always been strong economies of scope between the provision of network infrastructure and the provision of services on that infrastructure. These economies of scope still exist, although their strength is declining with technological change.

The businesses that create value through these economies are not necessarily the businesses that capture it. Technology can also create market bottlenecks which confer economic power, and allow certain industry participants to capture a disproportionate share of economic value-added produced by others. If this power is exercised in international markets, the result can be significant services trade imbalances between countries with strong positions and those with weak positions.

2.2 The analog legacy and the digital future

In order to understand these shifts, it is necessary to understand the differences between the technologies that underpin the traditional and convergence services sectors. The principal technology trend is the progressive digitalisation of services industries that previously relied on analog or physical networks to deliver their outputs.

Prior to the introduction of digital technology, all communications networks were comprised exclusively of 'analog' electronics that represented the content of communications - voice or video - as a direct electronic copy of the original content. For example, the sound waves from a human voice were converted into electrical waves by a microphone, transmitted through wires, and converted back to sound waves again at the other end of the line. Analog television works on the same principle, although the system needs to be more complex to cater for both pictures and sound.

The inflexibility of analog technology makes it difficult and costly to provide intelligent and configurable services, so the traditional services sector was limited in the way it could address individual needs. Standardised services, widely deployed, were the result. The high cost of analog infrastructures also prevented the emergence of international infrastructures spanning national markets.

In order to understand the current policy framework and the issues that convergence raises, it is necessary to understand how analog technology is related to traditional industry structure. The past dominance of analog technologies has had three key structural consequences:

• strong economies of scope promoted vertical integration of infrastructure and services. This has placed service definition and development firmly in the hands of infrastructure owners;
• strong economies of scale promoted horizontal integration of infrastructure. This has placed economic power in service, input and consumer markets into the hands of infrastructure owners;
• technological limits to the creation of international infrastructures, combined with the integration of service and infrastructure, confined service markets within national boundaries.

The three technological/structural features (distinct and vertically integrated industries, dominant infrastructure providers, and domestic market scope) were the basis of the regulatory model that applied to all services industries before digital technology, including telephony and broadcasting. National regulators were able to control service providers on an industry-by-industry basis by controlling entry to domestic infrastructure markets. Almost all communications regulation was implemented in this way until the beginning of the 1990s.

Digitalisation and convergence

The spread of digital technology throughout the services sector is the key enabler of convergence. Digital technology is imposing its own structural consequences on the services sector, and is undermining the industry structures and regulatory frameworks inherited from the analog era.

Digital technology differs from analog technology in the way it treats the data and signals which travel on networks. Instead of representing a signal as a true electrical copy, it represents signals as numbers. All forms of content and transaction can be encoded as digital numbers: video, audio, text, and financial data. Once these different types of content are digitally encoded they all have the same form, and can be carried on the same digital network. The network doesn't know or care about the substance of the data, only its form.

There are three reasons why digitalisation is having such an important impact on industry structure:

• Digital networks allow third parties to develop and deploy their own services across these networks, so infrastructure owners no longer control service offerings. This is eroding the economies of scope between services and the means of delivery, and promoting vertical separation between the services which users see, and the underlying infrastructure and delivery procedures (or 'connectivity'). New economies of scope are emerging as digital capabilities allow users to customise services and to actively participate in economic value creation.
• The emergence of standardised interfaces for digital network interconnection, along with rapidly falling digital technology costs, have weakened the economies of scale in the provision of infrastructure. This is facilitating increased competition in infrastructure markets, which is eroding the economic power traditionally wielded by infrastructure owners.
• Falling technology costs have flowed through to much cheaper international communications. Combined with the vertical separation of service and infrastructure, this has allowed the emergence of international markets for digital content and other services.

Economies of scope, vertical disintegration and mass customisation

Wholesale markets for access to digital networks are emerging. This has allowed independent third parties to develop and deploy digital services to customers over the digital network platform. The proliferation of websites and of other Internet-based applications is a good example.

This is similar to what occurs in personal computer technology. A computer can run a variety of third-party applications, and the digital network can do the same. Each service - a financial transaction service, an entertainment service, and even a voice service - can be identified with the networked software application that provides it.

This has broken the nexus between service provision and infrastructure ownership. The result is a growing structural separation between the provision of connectivity (and the underlying network infrastructure), and the provision of the networked applications that exploit that connectivity. This has led to new competition between traditional service offerings and new offerings from applications development industries outside the control of the traditional services sector incumbents, increasing the level of service innovation.

The capabilities of digital technology also allow for services to be re-programmed by users to better meet their own needs, weakening the service providers' hold on service definition. 'Mass customisation' of services by users is now possible, utilising information provided wittingly or unwittingly by users. The contribution of users to service definition is a powerful source of economic value in convergence service markets. This value is multiplied if information about users' preferences can be exploited across a range of services, rather than just one.

The structural consequence is that service providers have a strong incentive to diversify their service offerings, particularly into industries where customisation is a competitive advantage and user information can be exploited. Service providers without this relationship to the user (e.g. traditional broadcasters) are in a relatively weak competitive position unless they diversify their business into new areas or implement new business models where these relationships can be developed.

This also has important implications for competition in consumer markets. A service provider in possession of detailed information on a user's preferences is in a strong position against competing service providers in seeking that user's business. The result will be the consolidation of activity around the businesses which can best manage and exploit user information databases. These databases, and the capacity to manage them, will become new bottleneck assets and a key source of economic power in networked service markets.

Proprietary technical standards are another source of bottleneck power in interface markets, particularly the interface between the network and customer premises equipment. To understand why, it is necessary to remember why standards are used at all. When standards are adopted across an industry, positive externalities are generated because technical costs are lowered for everybody. This is true of both open (i.e. free) and proprietary (i.e. licensed) standards.

The key difference between an open standard and a proprietary standard is that a proprietary standard allows the owner of the technology to appropriate some or all of these externalities through licensing royalties. This is why technical standards are emerging as a key competitive battleground in the computing, Internet messaging, digital TV, digital video and digital music industries.

The imposition of a proprietary standard places the technology owner in a powerful economic position. This does not necessarily mean that a proprietary standard is a bad thing. Proprietary standards are better than no standards at all, but there is a significant temptation for holders of any bottleneck power to abuse their position. In certain circumstances, refusal to licence a dominant proprietary standard can amount to an attempt to eliminate or exclude competitors.

Economies of scale, competition, and wholesale markets

Digital technology is cheap and flexible compared to analog technology. It also makes it much less costly to interconnect different networks, because it is relatively easy to specify standardised interface technologies that allow competing networks to be connected.

In the telecommunications industry (where digital technology has become common) competing carriers and service providers have exploited these capabilities to gain access to Telstra's network. This has eliminated the need to replicate Telstra's infrastructure in order to offer voice and data services.

At the same time, alternative sources of digital connectivity have begun to emerge, notably the computer, digital radio and digital television broadcasting industries. As a result, an interconnected portfolio of competing digital networks has begun to take shape. Connectivity is increasingly being provided in competitive wholesale interconnection and access markets, and being traded as a commodity rather than a premium or specialised product.

This is weakening the economies of scale and scope that had previously prevented infrastructure-based competition and integrated the provision of basic connectivity with the provision of underlying infrastructure. New entrants in the infrastructure market, and new wholesale markets for access to infrastructure and basic connectivity, are reflected in vertical and horizontal separation of the telecommunications industry.

The pace of innovation and the level of competition have increased because of these developments, but economies of scale and scope still matter. New entrants have tended to concentrate on high-value markets where the disadvantages of small size and limited infrastructure are offset.

Convergence business activities

The result of these changes is the emergence of a different structural model for service provision on digital networks. This model is based on the technological characteristics of digital networks, but it does not attempt to capture the full complexity of the electronic services sector. For example there are many intermediate access markets in the connectivity industry, dozens or hundreds of interconnection markets, and there are thousands of different types of applications. The model simply illustrates the generic relationships between the principal businesses in a digital networked environment.

Seen from this perspective, services sector business activity occurs at three main levels.

The applications industry is about providing the functionality and services that users want. Users can be either persons or machines - a telephone call requires two human users, but an automated financial transaction can take place between two computers.

Applications may deliver content, but many do not. Examples of content-based applications are voice telephony services, radio broadcasting services, television broadcasting services, audio and video streaming services, and web browsing. Examples of non content-based applications are electronic commerce services, search engines, and networked data processing services. Some emerging services such as interactive entertainment are both content-based and transactional, and fully exploit the capabilities of the digital network.

Applications can be deployed by the owners of the underlying infrastructure, by third-party applications service providers, or even by users themselves, provided there is access to the underlying network. The number and type of different digital applications is only limited by the imagination of applications developers and the desire of users to pay for them.

Applications are digital software, and require an access device to interact with a person. The access device is often specialised for a particular application or applications. A mobile telephone handset is specialised for mobile voice communications, and a television set is specialised to display sound and video. The type of device depends on the requirements of the application.

The connectivity industry is about providing the links which applications need to connect users in different locations. Connectivity is simply managed digital bandwidth. There are many kinds of connectivity provided by different technologies: digital broadcasting capacity and telecommunications carriage services are obvious examples. The Internet provides connectivity according to a technical standard known as TCP/IP.

Many connectivity providers are not infrastructure providers, or provide only limited infrastructure. Telecommunications resellers and many Internet Service Providers (ISPs) operate in this way.

The infrastructure industry is about providing the hardware and basic operating functions which underpin the provision of connectivity and applications. This includes the provision of digital telecommunications infrastructure, networked digital radiocommunications equipment, digital broadcasting infrastructure, and Internet infrastructure such as servers and points of presence.

Infrastructure providers are generally also connectivity providers, although some local governments and utilities are developing plans to provide 'dark fibre' (i.e. unused optical fibre) and similar infrastructure for use by other infrastructure and connectivity providers.

Convergence industry and market boundaries

Different digital networks are potentially competitors for the supply of the connectivity. In addition, digital applications services and traditional services are in competition for revenues and customers.

As the capabilities and bandwidth of digital networks increase over time, the level of this competition and substitution will increase. This means that applications, connectivity and infrastructure markets are progressively being linked into three corresponding industries.

The activities undertaken in the applications, connectivity and infrastructure industries are illustrated in the following exhibit. These industries include not only electronic services, but also other types of service that are, at least potentially, substitutable.

The fundamental difference between the analog and the digital paradigms is embodied in the idea of an application. In an analog system (e.g. the traditional telephone network) or physical system (e.g. a system of retail outlets), the functionality of the system is indistinguishable from its delivery. The infrastructure and the procedures which make the business work are the service that the business provides.

In contrast, on a digital network there is a clear distinction between the application (which provides the functionality) and the connectivity (which provides the delivery). Control of one does not necessarily provide control of the other.

The applications/connectivity dichotomy recalls the distinction between carriage and content which is common in broadcasting policy debates. There is an important difference. Applications include a wide range of services that are not content-based, including electronic commerce transactions, electronic mail, and search engines. Digital broadcasting services and online newspapers are simply members of a special class of application, one that transmits content with minimal interactivity.

All real networks are a hybrid of the idealised models presented here, but some real networks closely approach these idealisations.

The traditional broadcasting industry closely follows the 'analog model' of vertical integration and supplier control of service offerings. This reflects the very limited penetration of digital technology into the broadcast delivery networks. Where digital technology has penetrated (notably in satellite broadcasting), the business model more closely resembles the digital model. The broadcasting service (the application) and the satellite connectivity and infrastructure are provided by separate businesses, but the lack of interactivity still leaves the service provider in control - although that will also change soon.

The telecommunications network is a hybrid of digital and analog technologies. Digital technology has completely displaced analog technology on the national and international trunk network, but the local access network remains an analog bottleneck on the exploitation of the network's digital capabilities. As a result, the telecommunications industry has been fairly slow to adopt convergence modes of business. This is set to change as digital data technologies invade the local loop, creating an end-to-end digital network.

At the opposite extreme, the Internet closely follows the digital model. The Internet is a 'dumb' network which places almost no technical constraints on the type of applications which can be deployed by any person.

The result of this open network philosophy has been an unprecedented level of service innovation on the Internet over the last four years. This boom in innovation triggered initially by the spread of web publishing, and has been followed by Internet search engines, electronic commerce applications, free email services, advanced messaging applications, and a host of other new services. It is no exaggeration to say that four years of the Internet have generated more service innovation than the previous forty years of broadcasting and telecommunications combined.

Internationalisation of connectivity and service markets

All electronic service markets are becoming, potentially, international markets, and the international market for networked services is not a level playing field. The economies of scale in the provision of digital switching and transit result in a structural cost advantage for countries able to attract and retain large international communications traffic volumes. This kind of cost advantage is an important element of competitiveness in international services markets, and across the economy where services are important inputs to business and households.

In the last four decades, a 'hub-and-spokes' structure has developed where international communications links (particularly undersea cable) tend to terminate in the US, and most international connectivity is hubbed through the US. As economies of scale have increased, the United States' strong position in international communications markets has been entrenched. Most of the Internet content in the world is stored in the US. In 1998, most European Internet traffic was being hubbed through Virginia, and most international Internet traffic in the South-East Asian region (including Australia) is still hubbed through California.

This kind of self-reinforcing advantage is familiar in economic geography. In international electronic services markets, the source of competitive advantage is not the economic geography of trade routes but the economic topology of networks. The shape of the network determines which nodes enjoy the benefits of the economies of scale inherent in digital technology, and which nodes capture the bulk of the economic benefits generated by international service sector activity.

The cost advantage derived from economies of scale in international connectivity makes North America attractive to applications and content service providers. The consequence is that Australia's international environment is currently dominated by a single external hub for both international communications transit and electronic services development, and this hub is strongly positioned to exploit its advantages of scale and the depth of its capabilities. The cental question for our international competitiveness is how Australia can best prosper in an environment where competitive disadvantage is a structural feature of the market.

2.3 The scope of convergence and the role of the demand side

This discussion so far has been conducted as if digitalisation will affect all service industries equally, and has practically ignored the impact of user demand. This section discusses the way that industry specific and demand related factors will complicate the simple supply-focused picture.

The scope of convergence

Different industries will be affected by structural convergence to different degrees. The most important factor that determines this impact on any given industry is the extent to which digital networks actually provide an alternative delivery channel in that industry. If digital technology presents no challenge to existing business models either directly or through new digital competition, then structural convergence is unlikely to have much impact.

Technology factors may also affect the extent of structural convergence. The discussion up to now has assumed that it will be technically possible to interconnect networks, and for third-party applications developers to have easy access to underlying connectivity. If this expectation is not met, then complete structural convergence might not occur:

• Any persistent differences between the technical standards on different networks could prevent the emergence of interconnection markets for the transfer of digital data. This would entrench traditional industry 'silos'.
• The imposition of restrictive commercial conditions (such as pricing) or technical standards (which might impose technical restrictions on applications developers) in wholesale markets could discourage third-party service deployment and innovation.

Demand side factors in service markets

The potential of the digital supply side to create an interconnected, international platform for services is constrained by the realities of demand. There are two areas where these constraints are strongest.

First, demand will be the most important constraint on the internationalisation of service markets because patterns of demand in different geographical markets will vary. A service that is accepted in one locality, country, or region may not necessarily be successful in another. Demand patterns depend on tastes, cultures, and income and education levels. Each of these factors depends in turn on geography. Not all services will be deployed internationally because demand could be global, regional, national, or even local in scope.

Second, user preferences about access devices will constrain the way that service offerings can be deployed. For instance, it is not clear that users want to operate interactive services through a television set (which is associated with passive entertainment), or want to operate passive entertainment services through a computer (which is associated with interactive applications), but either might eventually come to pass. These decisions will be crucial to the way services can actually be deployed in households.

User preferences for access devices may also have important implications for industry structure and economic power. Different convergence industry participants 'own' different user devices. The television industry has access to digital TV sets, the telecommunications industry has access to telecommunications devices like ordinary and mobile phones, and the computer industry owns the personal computer. Each industry has a head start in deploying new applications on its own devices, and will enjoy a competitive advantage and possibly bottleneck power in that environment.

It is possible that different devices will remain dominant within their own industry silos, and that different devices remain associated with the most important services. In that case a level of 'silo' segmentation of the applications industries may persist indefinitely. Alternatively, if one of these devices (e.g. digital television or the personal computer) became dominant across a number of industries, then one group of industry participants could capture a dominant position across the entire applications industry.

2.4 Convergence business strategies

Established service businesses have more at stake in convergence than the emergence of new competition. The traditional business model itself is at stake.

Control of infrastructure was the key competitive advantage in the analog world because service definition requires control of infrastructure. The successful businesses were those that leveraged their control of infrastructure to deliver standardised services across large markets, and exploited economies of scale.

This supplier-driven business model has been the foundation of the mass marketing approach to services. In almost every service industry where analog networks or physical distribution is dominant there has been a strong emphasis on the supplier definition of service and the mass marketing of standardised services. This is just as true of health and education services (which use physical infrastructure) as of electronic services like telephony, radio and television (which use electronic networks).

This business model created powerful incentives for consolidation. The result was entrenched oligopolies or even monopolies for service delivery. In an analog world, that is the most rational way to organise the supply side. These arrangements were often reinforced by regulation which restricted market entry and was designed to preserve these economies of scale.

In a convergence industry structure, none of these strategies make much sense. Control of infrastructure does not flow through to control of service offerings, because the wholesale market for connectivity makes it possible for applications service competitors to enter the market even if they have no infrastructure. It is impossible to block new competition that undermines established oligopoly strategies. Nor can service definition alone provide the old economies of scale if users are increasingly in charge of service definition.

There are two basic strategies that service industry participants can adopt to respond to these developments:

• a defensive strategy designed to preserve traditional economies of scale and scope and traditional business models; or
• an offensive strategy designed to exploit new economies of scale and scope and new business models.

There is nothing to prevent these two strategies being adopted simultaneously. The successful management of the transition from traditional to convergence business models and industry structures will require a mixture of defensive and offensive tactics.

Defensive strategies

There are a number of defensive strategies that incumbents can adopt to entrench or recover their traditional vertically integrated business models. These strategies generally aim to block or distort the development of the intermediate markets which allow third party providers to enter services markets without building their own infrastructure. This sets up significant barriers to entry. If entry can be controlled, it is then possible for the incumbents to set the terms of service provision without pressure from competing business models.

Blocking the formation of intermediate markets for connectivity would re-establish the nexus between control of infrastructure and control of service offerings, and preserve the traditional business model. This strategy requires the support of regulators, and can only be effective as long as no alternative service delivery channels exist. As soon as alternative digital platforms capable of carrying the service are available (say over a broadband Internet), new service entrants cannot be stopped.

Distorting the development of intermediate markets does not prevent third party deployment of applications services, but it can minimise its impact. This can be done a number of ways:

• manipulating the regulatory system to minimise the range of services subject to access and interconnection regulation, hence restricting access to the full power of the underlying network;
• establishing dominant proprietary technical standards in intermediate markets, and using technology licensing to control the entry of potential competitors;
• spoiling industry attempts to reach consensus on technical standards in intermediate markets. This will raise costs for third-party service providers because it forces them to develop different technical solutions for different standards; or
• using residual monopoly or oligopoly power in infrastructure or connectivity markets to restrict intermediate market offerings, and hence constrain the type and power of the third-party applications that can be deployed.

The result of any or all of these distortions would be a quasi-vertical re-integration of the connectivity and applications markets. This would not entirely prevent new entry, but it would tip the competitive playing field in favour of incumbents who are the principal infrastructure and connectivity providers and give the incumbents time to readjust their business strategies to the new industry environment.

Offensive strategies

The main offensive strategies are designed to capture the benefits of new economies of scale and scope. The primary economies of scale and scope in a convergence context are:

• economies of scope between user groups and service provision, based on the mass customisation of services to user requirements;
• economies of scope in the development, deployment and marketing of diverse service offerings in consumer markets. These economies are based on the exploitation of common costs and investments in developing brand recognition, user relationships and user databases; and
• ongoing economies of scale and scope in the provision of network infrastructure and connectivity.

Economies of scope between service providers and users are due to the customisation of services to individual users or user communities. The user database built up by service providers is a key business asset in the electronic services market. Knowledge about users allows service providers to tailor services, avoiding commoditisation of their services and increasing the value of the relationship to both service provider and user. It also helps to stabilise the customer base and reduce costs by reducing customer churn.

These benefits are only available to service providers who have the opportunity to develop such databases, acquire them, or already possess them. The 'lock-in' of users to particular service providers through customisation of services is a form of quasi-vertical integration.

Bundling of a wider suite of services also generates economies of scope because many of the assets used to develop, deploy and market one service can be used to develop, deploy and market other services as well. Alternatively, strategic alliances with other types of service providers can achieve similar results.

The kinds of assets that can be leveraged across a range of services include databases of information about user preferences, recognised marketing brands, and other forms of intellectual property like specialised management or technical skills. Offensive strategies can be employed to leverage these assets:

• A diversification strategy can reinforce lock-in of users if it includes areas like financial services where transfer costs for users are high. This strategy may prove attractive to providers of content-based services such as broadcasters. Customers change their bank far less often than they change their television or radio channel.
• Lack of consumer confidence in online service delivery increases the value of recognised and trusted brands. This provides opportunities for established service firms to leverage trusted brands into the online environment.
• Specialised skills and intellectual property can be applied to niche markets across domestic and international customer bases in order to maximise returns on intangible investments. The importance of this strategy depends on the relevance of the business' existing asset base to new demand markets, or on local strengths in unique skills sets. Barriers to international service provision such as trade restrictions, lack of intellectual property protection in target markets, or lack of digital and physical infrastructure in target markets can make this approach difficult.

Economies of scale and scope are still available, albeit reduced, in the business of digital network infrastructure and connectivity. There will continue to be considerable value in operating large digital network infrastructures and leveraging these assets into a variety of connectivity markets. This is not inconsistent with the continued growth of connectivity businesses which use limited infrastructure, because these businesses may have distinct advantages in specialised markets where connectivity is not a commodity and scale is not an issue. However, it suggests that the bulk of the connectivity market will be in the hands of large infrastructure providers who are in a position to provide connectivity more efficiently.

2.5 Convergence and input markets

The impact of convergence on input markets is twofold:

• structural changes in the applications, connectivity and infrastructure industries will be transmitted upstream into the input industries as the nature of industry demand changes; and
• digitalisation will directly affect the business processes in each input industry, just as it is affecting business in the wider services sector.

The digital content industries

The industries which will be most affected by convergence are the ones where digital technologies are a substitute for traditional technologies. The clearest examples are the film and music industries, where digital production techniques and physical media are well established. In contrast, publishing and the performing arts are less affected.

The digital production industries in Australia have generally been characterised by highly fragmented and subscale activity. Large (often foreign) companies wielding bottleneck power through their control of retail networks and major marketing channels have dominated domestic and international distribution.

Ownership of copyright on content also does not confer any bottleneck power which might offset the power of distribution. One movie or music album is normally substitutable for many others. Bottlenecks do exist in the production industries, but the bottleneck asset is not content. The bottleneck asset is the scarce management expertise that extracts the maximum return from investments in content production.

Movies are the best example of this phenomenon. The core business of the major movie studios in the United States is not making movies, and has not been for years. The core business of the major movie studios is managing intellectual property across as many distribution channels as possible. In practice, this means making significant investments in creative inputs, and leveraging movies across other forms of media such as books, music, television, computer games, and even toys. The result is not always high art, but this is the process which generates the revenues that underpin new investment, both for productions aimed at the mass markets and for innovative productions being developed at arm's length from the major studios.

In contrast, the fragmentation and subscale nature of most Australian production activity have prevented producers from generating the economies of scale and scope enjoyed by their US counterparts. This is the key reason for Australia's failure to match US productivity in these industries. Instead, output quotas (i.e. local content rules for television and radio) and direct government funding are used to maintain the critical mass of activity needed to preserve physical and human capital.

The results of this industry structure are:

• high cost of capital, due to the reliance on external funding;
• difficulty in maintaining a depth of creative and technical expertise due to low throughput;
• poor utilisation of management and marketing skills, particularly intellectual property management skills; and
• a weak bargaining position due to concentration in downstream distribution.

To sum up, the production industries in Australia already face some significant structural challenges. It is natural to ask whether structural convergence in downstream service industries (television, radio, music and film distribution) might improve or worsen their position.

The convergence trends identified in this chapter will have a significant impact on the production industry environment. As markets for content-based services internationalise, local production will feel the full impact of the US dominance in content production. The structural separation of broadcasting services and digital infrastructure will also make it harder to enforce local content requirements through market entry conditions.

Some artists have used technology to circumvent distribution chains, but this has only worked well where an artist has a highly loyal following and has been able to maintain production standards. It is a niche marketing approach. No-one has suggested that this could be a mass marketing channel. Mass marketing is the very discipline at which the established distributors excel, and that expertise is costly to replicate.

This suggests that powerful intermediaries will continue to mediate between content producers and audiences in most cases. The argument that content owners will automatically benefit from growing demand for content rests on the assumption that a significant number of new content-based services will emerge, and bid up the price of content inputs. It is not clear that this will happen. It is not even clear that new content for new types of service is needed, since reformatting of existing content may be all that is required in many cases.

It is unlikely that the Australian production industries could ever match the US dominance of this kind of business. It is not even clear that aping US business strategies is the best strategy available. If not, then other ways of addressing Australia's structural diseconomies need to be found.

This need may become critical when technology develops to the extent that direct networked delivery of music, film or television is possible over international digital networks. That day has already arrived for radio, is very close with CD-quality music, and will come soon for film and television. A range of new business models will then be possible: subscription services, pay-per-view (or pay-per-listen) services, limited life recordings which expire after a fixed period, and traditional purchase. The parallel importing rules that have mitigated the impact of US economies of scale on local production will then be redundant, and there will be no alternative to operating successfully and sustainably in an international environment.

Software and equipment industries

Digital software development will become the common currency of applications, connectivity and infrastructure industries as digitalisation penetrates all levels of the networked services sector. Even in the digital equipment industries, the hardware is simply a receptacle for the functionality that the programming provides, and the value-added is primarily in the equipment's embedded programming. The boundaries between the software and equipment industries have become blurred as a result.

The structure of the software and equipment industries in Australia is similar in many ways to the content production industries. These industries tend to be dominated by multinational companies, supplemented by a large number of medium and small-sized local companies. These multinational companies dominate the key value-added activities like large-scale systems integration and applications development. While it is possible for government programs and purchasing policies to raise the overall level of activity in the Australian-owned industry, it is very difficult to arrange for the transfer of the most sophisticated skills to these companies.

It is unlikely that convergence will result in a structural shift in the position of the Australian-owned software and equipment industries. The large participants in the applications, connectivity and infrastructure markets will probably outsource their major development and purchasing activities to the firms capable of developing and deploying software on the scale required. It is possible that software and equipment companies will have opportunities to diversify into online service provision, gaining an edge through innovation. The most likely outcome would be for such companies to eventually strategically align with, or be acquired by, a larger service company seeking to diversify its service offerings.

2.6 Summary and principal conclusions

The key structural convergence trends identified in this chapter fall into three main groups.

The emergence of new intermediate markets and industry structures

Structural separation between the services (which users see) and the underlying delivery mechanisms is growing. This distinction is reflected in the difference between applications (which represent services on a digital network) and underlying connectivity and infrastructures (which are the delivery mechanism).

In addition, weakening economies of scale in infrastructure provision are leading to erosion of bottleneck power in connectivity and infrastructure markets. Emergence of interconnection markets is gradually linking digital networks into a delivery platform spanning the services sector. Varying degrees of substitution between traditional and networked service delivery platforms in different industries are increasing the level of competition in both infrastructure and service delivery markets.

At the same time the importance of intangible assets as sources of economic value and centres of economic power is growing, especially assets such as trusted brands, proprietary standards, and scarce management skills.

Important unknowns are the extent to which the technical standardisation process and user preferences for access technologies will segment industries, and which industry participants and countries will develop and control the key intangible assets such as technologies, user databases, scarce skills and intellectual capital.

The growing role of user communities

The erosion of the service provider's sole control over service definition and the growing importance of user customisation are emerging as important sources of economic value and centres of economic power.

Important unknowns are the ways and extent to which users will be able to assert control of personal information through political or commercial means.

The growing internationalisation of service markets

Digital service markets are all potentially international in scope, because service provision is no longer integrated with domestic infrastructures. International markets for content, information and transactional services are emerging as third-party applications providers exploit cheap connectivity to address customers outside national boundaries.

The important unknown is the extent to which demand patterns will segment these international markets into regional, national and local markets, and how developing international traffic patterns will affect Australia's competitive position in service markets.

The consequences of these three trends can be summed up in a set of 'false dichotomies'. They are dichotomies because they represent two polar opposites in the way that networked service delivery is implemented and their industry effects. They are false because they represent ideals that no existing industry completely achieves. Nevertheless, they provide insights into the broad nature of the changes being experienced across the services sector.

Table 2.1 Key consequences of convergence

Key structural and commercial parameters	Traditional service industries	Convergence service industries
Technology of service deployment	Analog networks specialised for particular applications	Digital networks allowing deployment of multiple applications
Dominant structural model	Vertical integration of the service and the delivery infrastructure. Separate industry 'silos' for each service type	Vertical separation of the service and the delivery infrastructure, with wholesale markets for access to connectivity and infrastructure. Horizontal integration of 'service suites'.
Principal sources of economic value	Economies of scale in ownership of infrastructure and mass deployment of standardised services Economies of scope between infrastructure, delivery and service activities	Economies of scale in ownership of infrastructure Economies of scope from diversified service offerings Economies of scope generated by 'mass customisation' of flexible services by users and user communities
Principal centres of economic power	Ownership of infrastructure	Ownership of infrastructure Ownership of customer relationships, user databases, proprietary standards and other intangible assets
Locus of control of service innovation and definition	Infrastructure owners control the nature and pace of service innovation	Users and third-party applications developers control the nature and pace of service innovation
Geographical scope of service markets	Domestic or local reach confined within established national jurisdictions	International reach crosses geographical boundaries of national jurisdictions
Key constraint on international structural competitiveness	International structural competitiveness constrained by economic geography of international transport routes	International structural competitiveness constrained by economic topology of international networks

Part 2

• Document ID: 17478 |
• Last modified: 6 February 2008, 10:14am