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households (see Exhibit 8). Furthermore, Hong Kong's practice of providing free local calls has resulted in one of the highest usage rates in the world, reflecting the success of the Government's universal service policy.
3. Deregulation of telecommunications is a clear trend, but competition in local telephony is an exception rather than the rule. Led by the U.S., U.K., and Japan, a number of countries have begun to abandon exclusive franchises and allow the creation of competing public or private networks. Some countries have deregulated almost all services (e.g., the U.K. and Japan) while others have focused on generating competition in international and long distance telephone services. However, worldwide, real competition today exists primarily in long-distance calls and international telephone services, private networks, equipment sales, cellular communications, and other value-added services, not in local telephony.
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There are sound economic reasons why competition in local telephony has not been widely introduced. Local telephony serves low-price, short-haul traffic and must be low cost to be economically viable. Many countries, have recognized that there are significant and increasing economies of scale in local networks - in other words, unit costs decline
sharply as total traffic volume increases - and that a single network is the only economically viable solution. This is likely to be particularly relevant to Hong Kong, which is much smaller than the countries that have introduced local competition (e.g., the U.K. and Japan).
In the Modified Final Judgment that started liberalization of the U.S.
telecommunications industry, a central premise was that service by local exchange carriers
(LECs, the equivalent of Telco in Hong Kong) is a natural monopoly. In its 1987 report on competition in the telecom industry, the U.S. Department of Justice wrote:
"Fundamentally, LECs enjoy significant economies of scale and scope in the provision of short-haul transmission facilities....[An] LEC can move further down the declining cost
curve by consolidating not only large customers' but also small customers' short-haul traffic." Advances in switching and transmission technologies have further increased the economies of scale enjoyed by exclusive local carriers.
These basic economic realities may explain why, in New Zealand and Australia, for example - which have recently allowed competition in international and domestic telephony - none of the potential competitors has announced plans to build a local network,
McKinsey & Company, Inc.
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