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Equity and efficiency through local measured service.

Equity and Efficiency Through Local Measured Service

On January 1, 1984, a federal court ordered AT&T to divest itself of its Bell system of local exchange carriers (LECs) and operate only in the long distance market. To do this, AT&T formed seven regional Bell holding companies, which in turn held local operating companies. For example in the Northeast, NYNEX was the holding company and New York Telephone and New England Telephone were the operating companies or LECs.

The break-up of AT&T sent shock waves throughout the nation. The reason was concern over residential telephone rates. As a monopoly, AT&T promoted universal service through a substantial subsidy of local calls by the overcharging of long distance calls. With AT&T now in a competitive long distance market with firms such as MCI, Sprint, Comsat and others, no long-distance subsidy of residential rates was possible. The only alternative was to eliminate the subsidy by raising local rates significantly or to find another source for the subsidy. [10]

Resistance to raising local telephone rates by consumer groups forced the LECs to increase business phone rates above their cost and to hold the cost of calls within an area code (called a local access transportation area (LATA)) at the old AT&T rates. To protect the LECs' intra-LATA subsidy to residential phones, some states passed laws forbidding long distance carriers from entering the intra-LATA market.

Unfortunately for the LECs, the major 100 telephone user firms are responsible for about 80 percent of the total calls made on the telephone network. These firms, unwilling to subsidize residential phones, began a process called bypass. In by-pass, a business firm would contract directly with a long distance carrier for telephone service and by-pass the LEC. This meant the LEC lost a major customer who was providing a subsidy to residential phones. Thus the LECs had to raise business rates even higher, if they hope to avoid major increases in residential phone rates. [4]

Because of the fear of by-pass, LECs have tried to price all phones on a cost basis. Opposing cost based pricing are consumer groups who are bent on holding the residential subsidy. With increasing competition in the local phone market, subsidies to any sub-group of consumers cannot last. The solution is to gradually remove the subsidy as rapidly as possible, and the key to removing the subsidy is to substitute local measured service (LMS) for flat rate pricing of local phone calls.

Under LMS, local phone calls are priced on the basis of at least two of the following elements: (1) the number of calls made, (2) the duration of each call, (3) the distance over which the call is made, or (4) the time of day of the call. This is the method used currently for long distance calls.

Although LMS will be shown to be economically efficient and equitable. it has had limited implementation in the United States. Although 89.6 percent of all residential phones and 94.04 percent of all business phones could be priced using partial or full LMS in 1986, only 21.04 percent of residential and 45.00 percent of business phones actually used LMS. Most LMS is confined to New York City, Chicago, and Los Angeles, and these cities were converted to LMS many years ago. Therefore, these penetration figures do not fully reflect the general failure of more recent attempts by LECs to introduce LMS nationally.

During the 1980s, conversions to LMS have occurred voluntarily with penetrations of no more than 25 percent in areas where regulators permit it. The only recent non-voluntary conversion was in Vermont, which will be detailed below. The purpose of this article is to evaluate LMS and to show how it can help remove uneconomic subsidies of residential phones and as a result lower business phone costs.

Economic Justification for LMS

A fundamental principle of economics is that the price of a scarce resource should be based on demand. Further, if a commodity has a positive marginal cost but the marginal price to the consumer is zero (as with flat rates), then: (1) some will use the commodity inefficiently, or (2) those using the commodity more than average are being subsidized by those using it less than average.

Willig has shown that "any uniform price unequal to marginal cost is Pareto dominated by a nonlinear outlay schedule." [12] This means that any combination of optional LMS and flat (fixed) rates will make some better off and no one worse off than only flat rates. Utilities such as electricity, gas, oil, water, and even long distance telephone service are priced on nonlinear schedules for the same reasons. The use of a flat rate promotes excessive usage eventually making everyone worse off.

Mitchell used strong assumptions about the form of consumers' demand functions to show that it was possible to determine the distribution of preferences for the various usage patterns.[9] He used consumption data from flat rate customers to show that it would be possible to charge each customer on the basis of individual preferences. LMS is such a pricing scheme. Optimal pricing would be the nonuniform schedule that matched the preference distribution and allowed the LEC to cover costs. Brown and Sibley point out that Mitchell made several very restrictive assumptions about the demand function characteristics of the consumers. [3] They show that the distributions of tastes for telephone usage could differ even for the same demand function if assumptions are changed.

Nevertheless, there is agreement in the literature that demand is a function of both price and taste variables, and that this function can be used as a basis for pricing. While it is theoretically possible to combine flat rate pricing with optional LMS to match the demands of consumers, this pricing alternative will break down in time since the flat rate will increasingly have to be subsidized as more consumers move to LMS. As Kahn and Shew point out, optional LMS retains the unfairness of flat rates without the economic efficiency of mandatory LMS.[8] In summary, the economic choice for local telephone pricing is mandatory LMS.

One reason that flat rates persist is that many exchanges still do not have the computer facilities or digital switches necessary for low cost measurement of LMS. By 1970, availability of computers and electronic switches had significantly reduced the cost. In 1983, Beauvais estimated that average costs of measurement was $.001 per call.[1] Assuming an average call costs $.10, measurement costs are one percent of total costs.(1)

Another reason flat rates have persisted since the break up of AT&T is poor communications between the telephone companies and regulators on one side and residential telephone customers on the other. Flat rates are easy to understand and plan for. LMS takes more effort. There is small but vociferous group which like flat rates, including teenagers, large families, and socio-psychological talkers. Light users are more likely to be working adults as well as many elderly. None of these groups can be distinguished solely on the basis of economic status.[5]

The Flat Rate Subsidy

In residential phones, there are two types of subsidies: (1) a subsidy of residential rates by business phone and by intra-LATA calls, and (2) a subsidy of heavy users by light users. In this section, we discuss the second type of subsidy, because it needs to be removed first.

To determine the extent of the subsidy to heavy users from light users, the frequency distribution of number of calls is examined. Graph 1 shows a random electronically monitored sample of up-state New York flat rate customers serviced by New York Telephone. The average number of calls per month was 142.34 or 4.74 per day. The mode is approximately 45 calls per month and the median approximately 90 calls per month. Some people use the phone almost constantly with the bracket above 390 open ended.

The distribution of calls by minutes of use per call was also positively skewed with an average call of 5 minutes. The top 5 percent averaged 17 minutes a call, and the bottom 5 percent averaged 1.5 minutes per call. The relationship between number of calls and time per call is shown to be approximately linear. Heavy users also make longer calls.(2) This suggests that LMS that includes either frequency or length of call will be a reasonable proxy for a system that uses both.

Assuming that a minute call costs $.10, Table 1 quantifies the subsidies between heavy and light users. The last column gives the relative difference in subsidy and confirms the large subsidy from light to heavy users. For example, in March, the heaviest users cost the system $84.93 per month, while the lightest users cost $1.12 even though both groups paid the same flat rate. It can be shown that 72.3 percent of users would have lower rates under revenue neutral LMS pricing. The average cost of the subsidy for the 72.3 percent is $32.28 per year.

Table : TABLE 1

Telephone Use During March (Highest) and January (Lowest), 1984 New York Telephone Random Sample of 396 Users

Category Calls/Month Cost Min./Month Cost Total Cost

 Highest 5% 584 $58.40 2653 $26.53 $84.93
 Lowest 5% 8 .80 32 .32 1.12
Average 158 15.80 800 8.00 23.80

 Highest 5% 462 46.20 2130 21.30 67.50
 Lowest 5% 6 .60 22 .22 .82
 Average 123 12.30 615 6.15 18.45

In addition to the subsidy of heavy users by light users, flat rates support a cross subsidy of residential phones by business phones and by intra and inter-LATA toll calls.[11]. The residential phone subsidy is considered a public good by many consumer groups. Consumer advocates mistrust LMS because they believe it is a disguised method of increasing phone company profits and business profits at the expense of consumers.

This attitude was reflected in the intense battle over the effect of access charges on universal service. Michigan petitioned the FCC asking for a reevaluation of certain rules involving increased depreciation rates and access charges that were causing increased costs to local calling. Michigan argued that FCC rules were endangering universal service. The heart of the issue was the $1 charge in 1985 for residential phones as a phase-in response to the loss of the long distance subsidy. The FCC response stated that their decision "will bring consumers greater choices, lower long distances rates, lower local exchange rates in the long term through deterrence of uneconomic by-pass, and widely-available modern technology and service"[6]. They also pointed out that LMS may, in fact, be an important contributor to universal service.

The FCC based its conclusion on the elasticities of demand for telephone service. Demand elasticities indicate the percentage change in the demand for phones per percent change in price. Without LMS, elasticities range from 0 to -.24 with the majority under -.09. However, Perl shows that with options such as LMS rather than flat rates only, elasticities are about -.01.[6]. This reduced price sensitivity is a reflection of the flexibility LMS provides customers who wish to reduce their phone service costs. In effect, flat rates are themselves access charges and are currently higher than access would be under LMS.

Universal service was undefined in the Michigan petition. A 1980 census indicates that 92.9 percent of U.S. households have phones. Part of the 7.1 percent without phones are transients who would not have phones at any positive cost. Estimates of elasticities provide no indication that changing to a measured pricing scheme would jeopardize what may in fact be effective universal service.

The public good aspect of phone service to the poor has been recognized as legitimate by all parties to the pricing decisions. Current Vermont and New York tariffs provide a direct subsidy to the poor for phone usage through lifeline service without being an indirect subsidy to heavy users. A direct subsidy plus LMS is the lowest cost method of providing the poor with needed telephone service, while maintaining efficient use of economic resources [7].

LMS makes a great deal of sense economically, but its adoption has been slow. There have been several failed attempts by consumer groups to ban LMS through legislation in states such as California, Maine, Minnesota and Texas. Nevertheless, LMS is on hold throughout the U.S.

Experiments in Mandatory LMS

In 1975, GTE conducted a classic experiment in the introduction of LMS into local exchanges. Using three small cities in Illinois, GTE started a three phase program: pre-introduction attitudes, specimen bills, actual bills.

Prior to the introduction of LMS, surveys found that phone users in general believed that: (1) every resident used the phone more or less the same amount, (2) flat rates were the best way to bill for phone use. As the experiment moved into dual billing both of these beliefs changed. Consumers became aware of their actual patterns of telephone use. When LMS was made mandatory, many users changed their behavior, and, as a result, the demand characteristics of telephone usage in those cities also changed. Perhaps the most significant result of the experiment is that the preference for flat rates falls while that for LMS increases as the experiment progressed.

Furthermore a significant percentage of users recognized that LMS was more equitable than flat rates. Among the elderly preference for LMS exactly paralleled their use of the phone under flat rates. Heavy users preferred flat rates by 92% and light users preferred LMS by 91% [5].

The experiment highlighted important considerations telephone companies and regulators need to keep in mind. (1) Heavy users, although a small minority, will oppose LMS vigorously. (2) Users as a group prefer what they have, but they will adjust to change if they see it can be in their best economic interests [5].

The Illinois experiment demonstrates how important public relations are to both telephone companies and regulators wishing to introduce LMS. The experiment also helps provide an understanding of the disposition of LMS applications in New England. Vermont became the first state in the nation to mandate LMS.(3) In contrast Maine voters became the first to forbid all LMS. Both states are served by New England Telephone, a division of NYNEX.


Vermont's experiment started in 1982 with full optional LMS. Following the design of the Illinois experiment, the Public Utility Commission (PUC) targeted Burlington for the start of an information campaign that included dual billing. This city contains 20% of Vermont's telephones and had exchanges equipped with the necessary measuring technology.

By 1984 some opposition to LMS had crystallized and, after suitable hearings, the PUC took steps to guarantee the LMS experiment would be successful. They established the following guidelines: (1) LMS applied only to electronic offices (switches), (2) LMS must be either mandatory or not used, (3) LMS must be revenue neutral and could not be undertaken as part of a rate case, (4) LMS should include peak and non-peak pricing with peak from 9am to 9pm.

With these guidelines established, the PUC took a second crucial step for successful implementation. They established a bargaining group to determine the details of the LMS. The group consisted of the Vermont Public Interest Group (non-profit, consumer advocates), the PUC public advocate (a group associated with the PUC but dedicated to consumer interest), and New England Telephone representatives.

The results of their negotiations included an approved plan for a modified version of LMS with the following terms: (1) LMS would be in two parts, a charge for length of call and for time of day. There would be no charge for number of calls. Distance of call was not a problem because calls out of a local switch were intra-LATA toll calls. (2) A dual pricing system of $10.93 per month for access plus standard prices for use, or $17.53 per month with up to $9.45 of use included. To placate heavy users, there was a cap of $27.53 per month, and there was a $6 rebate for the poor (those at 125% or less of the U.S. poverty level).

With the agreement, Burlington was immediately converted to mandatory LMS. The results of the first three months showed that 75% of users reduced their phone bill in the first month and sixty six percent reduced their bills over the first three months.(4) Since its introduction, mandatory LMS conversion in Vermont has taken place as fast as the phone company can convert to electronic switches, and most users have welcomed the conversion.


In Maine, New England Telephone proposed optional LMS and dual billing with the same kind of information campaign used in Vermont. Even though dual billing showed the usual savings for most telephone users, opposition grew among consumer groups. In 1985, seven bills to delay or ban LMS were introduced in the legislature, but all failed to become law. At the same time the legislature gave no unified indication of their position. The PUC was outwardly supportive of the experiment, but it did not take a leadership position.

In 1986 consumer groups obtained sufficient signatures to place the following referendum on the ballot: "An act to prohibit mandatory local measured service and to preserve affordable traditional flat rate local telephone service at as low a cost as possible." The actual wording of the act contained a subsection that forbade the use of any alternative to flat rates if more than 25 percent of residential customers used such an alternative. Since as many as one third of the consumers in some exchanges were using optional LMS, optional LMS would be illegal. A New England Telephone company challenge of the wording of the ballot was rejected by the courts. The measure was passed by 58 percent to 42 percent. Exit polls indicated voter confusion concerning the bill. Many believed that they were merely defeating mandatory measured service, when in fact the referendum eliminated optional LMS as well.

The success of the referendum was caused in part by the publicity of consumer groups who believed a vote against the measure as tantamount to succumbing to the forces of big business. The implication was that the phone company was trying to dictate how they should use the phone, resulting in a loss of freedom of choice, and higher rates.

The contrasting results in Vermont and Maine are the responsibility of each group of state regulators and to a lesser extent the LEC. Regulators must see that all effected groups are represented and have an opportunity to effect a final decision within a set of reasonable rules. When regulators fail to do this the results are not necessary going to be either fair or efficient.

A Survey of Regulators on LMS

The attitudes of the regulators play an vital role in the telephone pricing outcome. For mandatory LMS to become a reality, regulators must take an active role in its promotion. In a recent survey of regulator attitudes [2], commissioners were asked to express a degree of agreement or disagreement with statements covering a wide range of pricing concerns. The national averages and the averages for the north eastern states are presented here for those items related to LMS (5 indicated strong agreement, 3 is neutral, 1 indicated strong disagreement. See footnote 5 for validation details).

Statement National Northeast

1. The most important consideration

for pricing decisions is ensuring

universal service. 3.4 3.4

2. The pricing structure for local

service that is closest to marginal

cost pricing is a combination of

subscriber line charges and local

measured service. 2.9 2.9

3. Special rates exist in this jurisdiction

to adequately provide

necessary phone service to the poor. 3.3 3.9

4. Universal service would be

threatened by the elimination of

unlimited flat rate residential

service. 2.8 2.7

These results are in agreement concerning the need to maintain universal service, but they disagree about the need for flat rates to protect that service. There is also disagreement that access and usage (typical LMS pricing) represents the pricing structure most closely aligned with costs. The region was more confident than the nation that the poor are being provided with adequate service. These results confirm a general lack of support among regulators for LMS as an optimal pricing scheme. The survey did not provide any insights about what the regulators would consider optimal, but it did suggest that active promotion of LMS that occurred in Vermont is not likely to occur nationally or regionally.


Americans are proud of their phone system with its universal service, and its flat rate low cost for residential phones. However, subsidized costs for residential phones were financed by AT&T's monopoly over all phones and especially over long distance calls in which business paid most of the inflated costs.

With the breakup of AT&T in 1984, the problem of maintaining the residential subsidy fell increasingly on business' local and intra-LATA calls. Now, however, businesses have an alternative. They can by-pass the local network and connect directly into AT&T or other long distance carriers. Some states passed laws to prevent this, but these laws have not been effective. As long as business phones were charged more than full cost, businesses would find ways of by-passing the local phone system, even if the by-pass was uneconomic to the economy.

Recognizing this problem, regulators and telephone companies searched for ways to price residential phone use at cost. The first step was to remove the subsidy within residential phone service; that is, the subsidy from light users to heavy users. The answer was local measured service (LMS) which was available on the majority of U.S. phones but was used by only 21 percent of the residential phones, primarily in New York City, Chicago, and Los Angeles where LMS had been established in the past.

Although optional LMS has been offered in several states it is not a long-run viable alternative to flat rates; only mandatory LMS will eliminate the subsidy of heavy users by light users. Unfortunately mandatory LMS has evoked irrational fear among residential telephone users that its implementation will mean higher rates and loss of universal service.

Alone among all states, Vermont has shown that mandatory LMS can be instituted, but it requires careful political groundwork. In contrast, Maine has shown that a confused public will vote to forbid all LMS, mandatory or voluntary, if public education about LMS is not carefully prepared.

Residential subsidies can not exist in a competitive market, and thus to keep the telephone system viable these subsidies must be eliminated as soon as possible. LMS is the ideal way of accomplishing this but needs strong support from businessmen, regulators, and academics in order to educate consumers about its advantages to the economy.


1. This number was developed from New York Telephone as follows:

From message rate (generic rate case #28978 Anderson working papers)

fully allocated costs are $978,681,000 and the number of messages

was 9,819,307,000 so FAC/message = $.0997.

2. The relationship between minutes of use and number of calls per month

in 1984 from a New York Telephone Company sample is:

Calls = 19.12 + .178 Minutes

(5.68)(*) (17.51)(*)

R square = .81, D-W = 2.03, F(1,75) = 306,

(*) t Statistic significant at .999 confidence interval.

3. LMS in Vermont is proceeding office by office. To convert to LMS an

office must be electronic. Full conversion should be completed in 1990.

4. Equivalent N.Y. State data suggests 72.3% of resident phones should

experience a cost reduction.

5. For details of validation see [2]. Each of the four responses in the text had

standard deviations that were less than one-third of the means. A paired

"t" test indicated that only question 1 was significant at the .1 level;

however, this does not mean the other questions are invalid, only that

they are not statistically significant.


[1.] Beauvais, Edward. "A Cost Benefit Analysis of Alternative Local

Service Pricing: Estimates From a U.S. Telephone Company." Centre

for the Study of Regulated Industries, McGill University, May 2, 1984.

[2.] Brown Kate, "Cost Based Pricing for Local Telephone Service."

Unpublished PH.D. dissertation, University of Connecticut, 1989.

[3.] Brown, S. J. and D. S. Sibley. The Theory of Public Utility Pricing.

Cambridge University Press, 1986.

[4.] Cole, L.P. and E.C. Beauvais. "The Economic Impact of Access

Charges: Does Anyone's Ox Need to be Gored." 14th Annual Conference,

Institute of Public Utilities, Michigan State University, December


[5.] Ellard, Timothy, "Dynamics of Consumer Attitudes", Perspectives on

Local Measured Service, J.A. Baude,, ed. March 13, 1979, pp. 161-173.

[6.] Federal Communications Commission, "Analysis of the Effects of

Federal Decisions on Local Telephone Service" CC Docket 83-788,

Common Carrier Bureau.

[7.] Hopley, John, "Life Line Service and Rates", Proceedings of Workshop

in Telecommunications Issues, University of Connecticut, January


[8.] Kahn, Alfred E. and William B. Shew, "Current Issues in Telecommunications

Regulation," Yale Journal on Regulation Spring, 1987, pp.


[9.] Mitchell, Bridger, "Optimal Pricing of Local Telephone Service",

American Economic Review, September 1978, pp. 517-537.

[10.] Noll, Roger, "State Regulatory Response to Competition and Divestiture

in Telecommunications Industry," Discussion Paper No. 124,

Stanford University, April, 1985.

[11.] Temin, Peter, and Geoffery Peters, "Is History Stranger than Theory?:

The Origins of Telephone Separations", American Economic Review,

May 1985, pp. 324-327.

[12.] Willig, R.D. "Pareto Superior Nonlinear Outlay Schedules", Bell Journal

of Economics, Spring 1978, pp. 56-69.

Kate Brown is Senior Lecturer in Finance, University of Otago, New Zealand and Professor of Finance, University of Connecticut; Richard Norgaard is Professor of Finance, University of Connecticut. The authors would like to thank John Triantis and Linda S. Klein for their assistance.
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Title Annotation:local phone companies' pricing scheme
Author:Brown, Kate; Norgaard, Richard
Publication:Review of Business
Date:Jun 22, 1991
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