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Emotions of Surprise and Concern Fanned by Telephone Rate Changes.

The current debate over proposed increases in local telephone rates is fraught with emotion. But as any debater knows, it is important to try to turn an emotional debate into one based on rationality. To do so, however, it is necessary to understand the emotions against which he is contending. In the present situation, it seems to me that those emotions can best be labeled "surprise" and "concern." Let's turn first to "surprise."

I can only respond to this emotion with the same emotion. I, too, am surprised, not by the proposed rise in rates, but by the surprise expressed by legislators, regulators, some economists and by at least one judge. I can only ask, "What did they expect?" Let me explain the reasons for my surprise and leave to these others the reasons for theirs.

For most of the past 50 years, telephone rates have been set with two goals: to promote universal service and to ensure that high-cost--primarily rural--areas were not disadvantaged visa-vis the low-cost (high-density) urban areas. These goals were achieved in two ways: (1) by constructing mechanisms which reduced the rates for local service below the costs users were imposing on the telephone companies; and (2) by the device of rate-averaging, which resulted in uniform rates for all users regardless of location, varying only by distance.

The principal mechanism for achieving the universal service goal wasM, of course, the separations process. By shifting an increasingly larger share of non-traffic-sensitive costs to the interstate markets, the charges for long distance service were held well above their economic cost; similar devices were used by state regulatory commissions to do the same for intrastate toll calls. Whether this resulted in "subsidies" for local service--as most economists would describe them--or whether the result was simply "support" for local service--as some regulators prefer to say--is a semantic distinction. The simple fact is that this process gave rise to rates which, although they may have had a laudable social objective, are not rates that can be justified on economic grounds. Competitive Evolution Not Random

It is important to understand why I make this distinction because it is the basis for my own surprise. Transforming the telecommunications industry from a regulated monopoly into a competitive industry started with the Above 890 decision, continued through Carterfone, MCI, the Specialized Common Carrier decision, the Execunet decision, the Second Computer Inquiry, and the Modified Final Judgment. This was not a series of random developments. All during this period a theme was developing that competition could and would better serve the interests of the consuming public than did regulated monopoly. This thesis was very strongly articulated by many of the same legislators, regulators and economists who now evince so much surprise. What they seem to have forgotten, overlooked or ignored is that a continuation of the subsidies that had been built into the system is inconsistent with the competitive environment that they espoused. Let me remind you that the inconsistency between subsidies and a competitive environment is not a concept suddenly arising of the MFJ. AT&T has for years been trying to alert regulators to the presence and implications of this economic reality. (I refer you to the record in FCC Docket 20003 and the record in the Department of Justice antitrust suit as but two instances of this.) The only ones who might claim surprise, therefore, would be those who know little economics or have never read there or similar records.

This is not the time--that time has now passed--to argue the relative advantages of regulated monopoly versus competition. The die has been cast in favor of competition. But we are now in a period when there may by some virtue in reviewing the price-related implications of a business environment that can be described as competitive.

First, as I have already suggested, subsidies cannot be sustained in a competitive environment. For if a supplier in such an environment were to attempt to subsidize the prices in some of his markets by pricing well above his costs in other markets, he would fail: entry by others into those latter markets will force him to reduce those prices, resulting either in a rise in prices in the subsidized markets or a reduction in his overall rate of profitability.

Second, in truly competitive markets, prices reflect the economic costs of supply, including a profit just sufficient to compensate the supplier for his business risk. Economists define economic costs as the marginal costs of supply; that is, price will reflect the costs of an additional unit of supply.

Finally, the consequence of driving prices to marginal costs in a competitive environment means that economic costs and, therefore, prices will reflect only causation; that is, they will reflect only those costs that are imposed on the supplier by changes in the demand for his goods or services, orther things being equal (such as inflation and risk).

When these three principles are compared with the traditional way in which telephone rates have been set, it can hardly be a surprising conclusion that restructuring of those rates is necessary if competition, and the promised benefits to be derived therefrom, are to be achieved. Pleased note here that I am referring to the structure of rates and not to their overall level--the latter may go up, down or stay the same in a competitive environment depending on inflation, depreciation policy, competitive intensity and other factors. With respect to structure, though, some rates will have to rise while others will fall. To state the obvious, those that must rise are the subsidized rates and those that fall will be the subsidizing ones. When this happens, and whether it happens in an orderly fashion, depends in large measure on the willingness of the surprised regulators and legislators, to whom I referred earlier, to let it happen. It will happen even if they legislate and regulate against it. But in that event, it may well happen in an uneconomic way which will more inexorably and more severely impair the interests of small local telephone customers. In The End It's Consumer Who Pays

The mayor revision in rate structure, initiated by the FCC in its Third Order in Docket 78-72, was to begin to eliminate the subsidization of local exchange by long distance toll by instituting an access charge to be paid by all telephone subscribers regardless of their volume of use. The access costs, eventually to be recovered through these charges, are definable costs which represent the cost imposed on the system by the customer's decision to become a subscriber. They do not vary if he increases or decreases his local exchange use, his interstate toll use, his intrastate toll use, or if he makes no calls at all. They usually are referred to as the non-sensitive costs of providing telephone service.

Although these costs are insensitive to usage, they nevertheless have been recovered through usage charges primarily on toll service. This means that users of very little long distance service pay substantially less than cost impose and high-volume users pay substantially, often many times, more than that cost. This king of cost/price relationship can be maintained in a regulated environment but it is unsustainable under competition because the overpayers must eventually be attracted away either by rival suppliers or through private bypass.

One of the most often heard arguments against the move to economically rational rates is that it is unfair for the interexchange carriers to be relieved of the burden of paying their share of these access costs. After all, it is argued, aren't they benefiting from the ability to access the customer? This argument overlooks two facts. First, it is not the carrier who ultimately pays, it is the consumer in the price of the goods and services he buys. Second, I say with some regret, the doctrine of fairness plays no role in the competitive model and, I hasten to point out, it is upon this model that all of the arguments are based in favor of replacing monopoly by competition in this industry. Rate Changes Should Be Gradual

This rather bald and seemingly heartless statement does not mean that I feel that there is no role for a conception of fairness as telephone rates are rationalized in a competitive environment. People have a right to expect reasonable continuity in the policy of their government and to not be subjected to abrupt changes as that policy is modified. Fairness, therefore, would require that the rate changes that result from the new policy be made as gradually as is feasible. I believe that the FCC's decision to gradually increase access charges over time is consistent with this concept of fairness.

But I do not consider it unfair to charge people rates which reflect the costs they impose on society. I do consider it unfair to impose on some people charges which are well in excess of the costs of serving them in order to provide, without regard to need, a subsidy to others.

I accept the argument that suddenly making telephone service so expensive that poor people could not afford it would be unfair since society appears to view that service as essential. To achieve this goal by subsidizing indiscriminately, however, is unjustifiable. Concern Is Warranted

This, then, leads me to the second emotion. While I view the emotion of surprise as indefensible, the emotion of concern is, I believe, quite warranted. This country has achieved an enviable level of telephone penetration. Currently, some 93 percent of the families in the United States subscribe to telephone service. It is not inappropriate to ask what might happen to this penetration if residential rates were to rise to the levels currently being discussed in regulatory proceedings. Other things being equal, it does not take a sophisticated econometric analysis to know that that number will be reduced. So does the consumption of bread when its price rises. But it does take such an analysis to estimate the degree of expected decline, to reveal those sectors of our society that are most likely to be seriously affected, and possibly, even, to uncover ways in which those impacts might be mitigated.

Our statistical evidence on this subject has, up to this point, been relatively limited. In fact, it has been almost completely confined to a study on access demand by my colleague Dr. Lewis Perl which was prepared in 1978 under AT&T auspices and submitted to the FCC in Docket 20003 and to Judge Greene in the AT&T/Justice Department case. Since then, others have used (and in some cases misused) the study to forecast the effect of price increases for specific states and socio-economic groups.

Recognizing the importance of these questions to the issue of restructuring telephone rates, the Central Services Organization (now Bell Communications Research) of the Bell operating companies has asked Dr. Perl to carry out a new study based upon the most recent data. That study, greatly expanded in scope especially with regard to rate structure, was completed last December.

The report assesses the effect of local service prices on demand for telephone service. Some readers will conclude that the effects we have found are trivial, while others will view them with genuine concern. Depending on the price changes contemplated and the economic and demographic characteristics of the area considered, either view may be appropriate.

Whichever view one takes, however, the results of the study should provide a basis for rational pricing policies. For readers who view the effects of price on telephone demand as "de minimus," the results should provide the basis for supporting pricing based solely on costs.

However, for readers who feel that fully implemented cost-based pricing will have unacceptable effects on demand, the study suggests that the provision of life-line rates to low-income consumers can mitigate the effects of such pricing while assuring that most consumers pay the full cost of telephone service. The Main Conclusions

I hesitate to burden you with any of the numbers in this report, but let me list some of its principal conclusions.

First, the study suggests that there has been a substantial increase in the demand for telephone service between 1970 and 1980. As a result, increasing access prices will have a smaller effect on access demand than had those changes taken place in 1970. The price elasticity of demand has decreased by about 40 percent.

Second, the study confirms the assumption implicit in the 1978 study that access demand is primarily a function of minimum rather than average access charges. This result suggests that the availability of measured rate service, with relatively low access charges or low-priced two-party service can be expected to maintain relatively high levels of access demand even in the face of substantial increases in the price of flat rate service.

But, third, demand also depends on local calling prices and even at very low access prices, some households will not subscribe to telephone service unless they can make a large number of local calls at a low price. Thus, any increases in local service charges, whether for access or local usage, will cause some decreases in the percentage of households with phones (telephone penetration). This result suggests that decreases in telephone penetration do not necessarily reflect decreases in the affordability of access to telephone service.

Fourth, there has been a marked narrowing in income-related differences in telephone penetration from 1970 to 1980. Nevertheless, there is still a significant disparity in penetration between the lowest and highest income households and this disparity will widen if prices increase markedly. This widening can be avoided by providing low-cost lifeline service to low-income households.

Let me stay on this fourth point for a few moments and go back on my promise not to ply you with statistics. Actual telephone penetration ranges from 80.5 percent for those in poverty, to 96.6 percent for those with average income (three to four times poverty) and 98.8 percent at the highest income examined. For the average-income household, a $10 increase in access prices reduces penetration by 2.6 percentage points. For high-income households, the reduction is less than 0.8 points. But for households in poverty, a $10 increase reduces penetration by 9.1 percentage points. Put another way, most people who drop off the network when prices rise are low-income households. Of those that leave when prices rise by $10, 27 percent are in poverty, 57 percent are below twice the poverty level and about 85 percent are in the lower half of the income distribution. I know of no more powerful argument in support of a targeted lifeline rate.

The fifth finding of the study is that the market for telephone service is characterized by an externality, that is, the value of being hooked up to the network depends on how many others are hooked up to it. But, the welfare gains from subsidizing access by pricing below its cost are quite small and may not justify the efficiency losses from any practical subsidy program.

Let me tell you what these results mean to me. First, the report provides evidence that earlier concerns about major impacts of rising telephone rates on the overall penetration rate should be substantially reduced. Second, there is clear evidence that using measured rates (an alternative not widely available when the original study was done) can do much to reduce the number dropping off the network. But, finally, even with measured rates in place, concern about the impact upon the poor is probably justified and this concern can be reduced by the introduction of targeted lifeline rates. There is, however, no justification in the data to meet this concern by keeping the rates for all residential customers below cost.

Let's return, now, to the two emotions: surprise and concern. For the concerned among you, let me say I believe that you will be persuaded that previous concerns were overstated, but that to the extent concerns still remain, they can now be founded on facts, not merely on fears. Finally, if you still remain surprised, I suspect I would also have trouble convincing you that water runs downhill.
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Author:Joskow, J.
Publication:Communications News
Date:Apr 1, 1984
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