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Prices, costs, externalities and entrepreneurial capital: lessons from Wisconsin.

BY DAVID GABEL(*) and DAVID L. ROSENBAUM(**)

I. Introduction

In Matsushita v. Zenith the Supreme Court gave a ringing endorsement to the Chicago school's view "that predatory pricing schemes are rarely tried, but even more rarely successful."(1) Consequently the Court clearly indicated that it would exercise great reluctance before finding for a complainant in this area.(2) The Justices noted that scholars like Easterbrook had shown that on theoretical grounds predation was unlikely to occur and further there was scanty empirical evidence documenting predatory behavior.(3)

In this article we document the predatory behavior by an incumbent, Wisconsin Telephone. We argue that Easterbrook's analysis of market behavior fails to explain the evolution of the telephone industry in Wisconsin because of his narrow view of business strategy. Specifically, we show that the incumbent adopted predatory prices in order to block the growth of a firm whose manager had well recognized entrepreneurial skills. The incumbent was willing to take losses in one market in order to prevent the entrepreneur from expanding his network.

A. Easterbrook on predation

Frank Easterbrook(4) has forcefully argued that either it is not possible to detect predation or it is unlikely to occur because of the low probability of success. Easterbrook points out that it is difficult to separate legally competitive from illegally predatory price reductions because the nature of the conduct is similar. He also argues that predation is too costly. A dominant firm with a large market share stands to incur significant losses during a predatory period. Even if a rival is driven out, the dominant firm has to acquire and then maintain monopoly power long enough to recoup its previous losses. This is not likely.

Throughout his article Easterbrook also implicitly promotes the notion that markets work "too well" for predation to be successful. A rival firm can ride out the predatory period in several ways. It can, in effect, "go dormant" and lose only its fixed costs. It may be able to find investors that will provide the capital to carry it through the short run to gain the profits available in the postpredatory period. Even if forced out of business, other firms could buy the capital assets at a lower price and potentially have lower costs than the dominant firm.

Easterbrook also argues that successful predation requires customers to cooperate with the aspiring monopolist. Easterbrook proposes that customers can counter the predator's strategy by stocking-up during the low-price period. The predator adopts low prices in order to drive out its rivals. The benefit comes to the predator when it raises its prices after gaining control of the industry. By stocking up during the low price period, customers can deny or significantly delay the predator the opportunity to recoup its initial losses. Easterbrook also points out that customers can sign long-term contracts with the prey to insure low prices well into the future. Market solutions are suggested even when consumers are myopic or purchases are too infrequent to warrant long-term contracts.

Easterbrook addresses the idea of signaling across markets as an incentive for predation. Again, he rejects this motive. With a finite number of markets, there is the problem of noncredibility. Also, predation in one market signals potential supracompetitive profits may either be available in other markets or become available in that market. These profits will act as an incentive either for rivals to hang on, for other firms to invest in the rival, or for entry in other markets. He even discusses the notion of coordination among a group of potential entrants to organize contemporaneous multimarket entry.

B. Separating competitive from predatory pricing

As noted by Easterbrook and others, it is difficult to separate competitive price cuts from predatory price cuts. Further, it is costly to society to make the error of mistakenly characterizing a competitive price reduction as a section 2 predatory action. The cost of this type of error must, of course, be balanced against the probability of characterizing predatory behavior as competitive.

Areeda and Turner have developed a cost-based rule to help separate predatory from competitive prices.(5) They argue that only prices below marginal cost should be presumed to be predatory. Others suggest rules that stress intent and structural impediments to competition without using a strict cost-based rule.(6) We agree with these latter approaches. Among other reasons, cost-based rules may be difficult to apply in some industries, particularly industries that exhibit the characteristics we discuss below.

Consider a dominant firm that operates in several markets that share joint capital. Let a rival operate in only some of those markets. Pricing in the shared markets below marginal cost imposes losses on the rival. The dominant firm, however, can offset those low prices with earnings from monopoly markets. As long as revenues from all markets cover combined marginal costs and the joint capital cost, the dominant firm remains profitable.

In this joint capital situation, the rival may be as efficient as the dominant firm, i.e., it may have the same cost structure. It is even possible that the rival may use a more efficient technology that gives it both a lower marginal cost and capital cost than the dominant firm. However, since the rival has to recover all of its costs in limited markets and the dominant firm can recover its joint capital costs across all markets, the rival may be driven from the market.

The analysis of joint costs as enabling strategic pricing becomes more intricate when joint costs are sunk. A variety of models show that sunk costs can act to deter entry.(7) Sunk costs also commit an existing firm to a market since those costs cannot be recovered upon exit. From the dominant firm's point of view, sunk costs in joint capital commit it to remain in all markets.

Sunk, joint capital costs put a rival in a more tenuous position. The sunk nature of the capital means the rival is hesitant to exit markets where it has already invested. But the joint nature of the capital imposes a cost disadvantage on the rival relative to the dominant firm. The joint nature of the capital also compels the rival to consider entry into other new markets. The sunk nature of the investment, however, discourages this entry, for the investment will be lost if entry is unsuccessful. Therefore the rival is destined to be at a cost disadvantage to the dominant firm unless it undertakes the risky sunk investment of entry into all markets.

Network externalities just exacerbate the sunk cost problem. Network externalities force rivals to make substantial sunk investments to get customers. Consumers, however, are hesitant to be early switchers to a rival's network, even when it is in place.(8) In effect, a gestation period occurs when a rival incurs considerable sunk costs and absorbs potentially little revenue. When these network costs are joint costs, the dominant firm can price low in the competitive markets and high in the noncompetitive markets. This eases engaging in pricing that is predatory in effect and allows a dominant firm to foster an entrant's belief that the dominant firm may respond aggressively to entry. This belief may convincingly deter future entry.(9)

In summary, when markets exhibit sunk, joint capital costs and network externalities, pricing problems can arise. A dominant firm can force the exit of rivals and deter the future entry of other rivals. Under these conditions, Easterbrook's logic may not hold. Predation may be profitable and reasonable. Low prices in limited markets may not impose significant losses on a dominant firm. Rivals may not be able to attract capital to weather a predatory period. Multimarket entry may be difficult and risky. It may be possible to acquire and maintain a dominant position.

That is not to say that predation always occurs under these conditions. Rather, a dominant firm may predate against its strongest rivals. The strength of a rival, in turn, depends on its ability to obtain capital, to expand quickly, and to attract customers as its network grows. Doing these things successfully requires the right kind of managerial talent. In a perfect market, this talent may be ubiquitous. In real markets, it may not.

The problems of sunk costs, joint costs, network externalities and human capital are particularly applicable to the telephone industry. Markets are segmented by product (local service, long distance, etc.) and by region. Capital costs are joint since the same capital can be used for local or long-distance service.(10) These capital costs are typically sunk. Significant network externalities prevail. Short-run marginal costs can be near zero in individual markets.

Successful entry that posed a threat to existing dominant firms occurred only in limited markets at distinct times in the industry's history. One such market was Madison, Wisconsin near the turn of the 20th century. The archival records of the incumbent, dominant firm, Wisconsin Telephone, and its rival, Dane County Telephone, provide a rich source of material on pricing strategies used to remove a strong rival managed by a threatening entrepreneur.

Joint capital and significant fixed costs pushed marginal cost well below single market average cost. The dominant firm's prices probably were above short-run incremental cost. These prices almost certainly would have passed an Areeda-Turner type cost-based rule; yet the intent of such pricing was clearly predatory. It was to remove a strong, efficient competitor before it could acquire the capital to become a more formidable regional competitor. Hence our call for an intent-based rather than strictly cost-based rule.

II. Predatory behavior in Madison, Wisconsin

We characterize the incumbent firm, Wisconsin Telephone, as dominant because of its first mover advantages and its extensive network. Bell's extensive network and presence in several markets gave it significantly greater resources than Dane County Telephone, the entrant. Wisconsin Telephone had the ability and exhibited the desire to engage in behavior typically recognized as dominant-firm pricing.

Local telephone service by a supplier other than AT&T was first offered in 1894, when Alexander Graham Bell's patents expired. The entrants, known as independents, quickly concluded that in order to remain in the market, they would have to build a network that linked together their local exchanges in the same manner that AT&T's Long Lines provided long-distance service. In 1897 the National Association of Independent Telephone Exchanges set as an objective the construction of such a network.(11) Subsequently, independents expended much effort trying to achieve this objective.

The entrants, approach to building a network was significantly different than AT&T's.(12) AT&T focused on building a national network and considered service in small, local monopoly markets as secondary. The independent companies were locally controlled and were strongest in rural areas and small and medium-sized cities. They initially established local service, which remained a primary concern, and then sought to develop regional networks that would be eventually connected into a national grid.

The Bell System was controlled from the East. AT&T owned the long-distance toll lines and was the majority stockholder in the Bell Operating Companies which provided local and short-haul toll service. They were also the dominant suppliers in large cities. Both officials of AT&T and the independent firms noted that local ownership provided the independents with some managerial advantage. The independent officials were more aware of local conditions, and they had greater latitude in adopting policies that met with the needs of the community.(13)

The independents needed capital for the construction of trunk lines that could expedite the completion of their long-distance network. But the independents experienced trouble raising capital; despite their recognition of the necessity for constructing a toll network, these companies faced financial constraints that prevented them from making large investments in toll lines.(14)

Consider an example. Wisconsin Telephone started exchange phone service in Madison in May 1879. The exchange started with thirty subscribers and had expanded to 100 subscribers by the end of the year.(15) Following this initial growth in subscription, Bell's customer list stagnated in the capital city. During the next 15 years, a period in which the firm had a monopoly, the company only added an additional 136 customers.

Prior to 1894 customers in Dane County, Wisconsin, frequently approached the Wisconsin Telephone Company and had requested that the company lower its prices and improve its service. According to the Wisconsin press, Bell "`contemptuously'" refused the customer requests.(16) After being refused pricing and service relief from Wisconsin Telephone, the citizens founded a competing "home company." At the end of 1895, the leading paper in Madison explained the reasons that it felt customers should abandon Wisconsin Telephone and sign up with the newly established competitor:

No monopoly in this country has practiced such outrageous extortions

as has the Bell telephone monopoly. Its charges have been without reference

to the cost of service rendered.... It has steadfastly refused

to make any concessions and brutally denied all petitions for relief.

. . . It never yielded an inch of territory, or consented to the slightest

reduction in rates until forced to do so by the presence or fear of competition.(17)

Sensing an opportunity for greater market development, and aware of the popular dissatisfaction with the service offered by Bell, B.B. Clarke, Samuel A. Harper, and Robert M. La Follette organized the Dane County Telephone Company in 1895.(18) Harper and La Follette are better known for the influence they had on Wisconsin politics. La Follette was later elected the governor and senator from Wisconsin, and made unsuccessful efforts to become the President of the United States. Harper was La Follette's law partner and political advisor. Harper was also the president of the Wisconsin Republican League. These connections were crucial because as with other utilities, the firm's success was very much a function of the arrangements that could be worked out with local and state governments.

The promoters, decision to construct a competing exchange in Madison was not finalized until after they felt they had obtained a sufficient number of customers--400--to justify the undertaking. Dane County Telephone had little trouble reaching this goal. By offering service for one-half the price charged by Bell, the new independent received strong support. On the first day of their subscription drive, eighty customers signed-up with the "homecompany." Seven months later, in January 1896, the company began operations with 400 customers, 140 more than the incumbent.(19)

Neither Samuel Harper nor Robert La Follette played a major role in the operations of the telephone company. The day-to-day operations were handled by Harper's brother, J. C. Harper. As the general manager of Dane County Telephone, J.C. Harper was responsible for all facets of the firm's business. Harper split his time between promoting good customer relations, supervising the maintenance and extension of the exchange, integrating the local telephone company's operations into a state and regional toll network, and lobbying local, state and federal politicians for favorable regulations.

During the first years of the firm, J.C. Harper spent considerable effort coordinating the construction of an independent toll network around Madison, and attempting to establish a larger, regional and national network. Because of the visibility of his work, independents throughout Wisconsin turned to Harper for advise on various topics. He had exhibited a keen interest in both state and national activities of independent companies. In addition, at the local level, he assisted new companies by advising them on the procedures of incorporation, helped draft by-laws, and gave advice on the best means of constructing plants. Harper, who always thirsted for information about the latest developments in the relationship between the independents and Bell, was also in frequent contact with officers of companies throughout the Midwest. Since he was the storehouse of so much information about the development of the independent movement, it was natural that he be a principal leader of any effort whose purpose was to improve the independent's market position.(20)

Wisconsin Telephone had to be concerned about the developments in Madison. All but six or eight of Wisconsin Telephone's 236 customers signed up for service with Dane County. Toll service was in its infancy, and therefore it did not provide the incumbent as large a strategic advantage against the "home company" as it would a few years later. Confronted with the possible loss of its entire customer base, Wisconsin Telephone made a "desperate effort" to keep its phones in service. Before Dane County began service, but after the independent had announced its intention to enter the market, the incumbent reduced its rates twice. By March of 1896, only 3 months after Dane County had started service, Bell had reduced its official rates to one-quarter of the level prior to entry, and had eliminated the line surcharge for suburban lines. Furthermore, Bell offered free service to the city government, many businessmen, railroads, and "`anyone having a phone who will let it remain, rather than being compelled to remove it.'"(21)

Bell did not consider its own rate cuts "legitimate." The general manager of the company described its tactics as "`war measures.'"(22) But these "war measures" did not convince the public to abandon their support of the "home company." A "prominent businessman," when asked to comment on the incumbent's offer of free service to the mayor and a number of businessmen and professionals, replied rhetorically: "`Why the change of heart in the great Bell corporation at this time? A school boy can readily answer.'"(23)

Neither did Bell's tactics prove successful with the city government. Despite the offer of free telephone service, by July 1897 the city government had ordered all the Bell telephones, with the exception of one in the police station, removed from its offices.(24) When Bell cut its rates, the independent companies maintained their customer base not only because of the public's disdain for the old monopolist, but also because the independents had used an entry strategy that provided them protection from retaliatory price cuts.

When Dane County Telephone established service in 1895, it required its customers to sign contracts that obligated them to subscribe for 3 years after service was initiated. In a letter to Robert La Follette, B.B. Clarke explained that these customer contracts provided the firm protection. Since customers were obligated by contract to obtain service from Dane County for a 3-year period, there was a reduced need to worry about Bell reducing its prices. The guaranteed revenue stream reduced the risk of the investment.(25)

Wisconsin Telephone asked its customers to sign 1-year contracts. B.B. Clarke realized that if Bell "adopt[ed] the plan of a long time contract and [gave] assurance of their intentions to keep up reasonable rates, and at the same time gave better service," the independents would have a difficult time sustaining their market presence. Long-term contracts were therefore seen as an effective response by the incumbent even after the entrant had secured a large part of the market through contracting.(26)

In October 1904, Bell considered, but apparently decided not to offer customers in Madison 10-year contracts "at a fair rate." Polling of customers had shown that if the contracts were extended, subscribers would discontinue service from Dane County Telephone. According to a Wisconsin Telephone employee, by offering long-term contracts, Bell would be able to overcome the public's perception that the company was trying to drive Dane County Telephone out of business so that it could subsequently raise its rates.(27) Unfortunately, the available records do not indicate why Bell chose to forgo long-term contractual contracts. As discussed below, the company shortly opted for a different, but more flexible form of contracting, state regulation. It may have been that the company felt that it was too risky to commit to fixed rate levels for 10 years.

A. The independents attempt to protect their markets

In 1899, only 3 years after its inception, the independent had 850 customers in Madison, while its competitor served 240 subscribers. The entrant was able to maintain the loyalty of the majority of subscribers in Madison; 7 years later it was providing service to 2500 subscribers, 1600 more than Wisconsin Telephone.(28) More toll calls were placed through Dane County Telephone's switchboard than through Wisconsin Telephone's exchange. Within a 30-mile radius of Madison, the independent network provided connection to 3500 other subscribers; Wisconsin Telephone only connected to an additional 250.(29) The overwhelming majority of toll calls made from Madison were short-distance.(30) Since toll calls were typically placed by business customers that had a comparatively high willingness to pay for service, the management of Dane County Telephone believed that the construction of a ubiquitous toll network was vital to the firm's long-term viability. Nevertheless, most of the firm's scarce capital was used to expand and upgrade their local network.(31) Despite being the largest supplier in Madison, Dane County had trouble raising funds for long-haul toll lines. Dane County's cash problems were due to Bell's policy of aggressively responding to entry.

For many years, Bell's rates at competitive exchanges were maintained at levels below the cost of operating its plant. In a submission to the state legislature in 1905, Wisconsin Telephone conceded that "[i]t is true that we have, in a number of instances, been forced by competition to cut the rates below the cost of giving service...." The losses, at times, were large and extended over a number of years.(32)

In 1905, Harper took a leading role in convincing the state legislature that Bell should not be allowed to practice price discrimination. Bell could sustain its overall profitability, despite the losses at competitive points, because of its large earnings in monopoly markets. The independents considered entry into all markets to be the optimal response to Bell's pricing practices, but this was not an option that was easily implemented. Various regulatory and financial barriers to entry, for example, blocked their entry to Milwaukee. Because of these impediments, the independents turned to the legislature for assistance. Under the guidance of J.C. Harper, the independents petitioned the legislature for legislation that prevented price discrimination.

During the 1903 and 1905 legislative sessions, bills were considered by the legislature that were designed to limit price discrimination by the telephone companies. Many citizens had objected to the railroad rate structure because they claimed different rates were charged for like service depending on market conditions. The railroads had replied that the rate disparities that were objectionable to many people reflected market pressures and were not the result of the companies, attempt to exploit customers with few alternatives.

Wisconsin Telephone's rate structure exhibited similar rate disparities. Its charges in cities with competition were significantly less than in monopoly markets.(33) But unlike with the railroad industry, the opposition to Bell's price structure did not come from political reformers. Instead the lobbying was initiated by the Wisconsin Independent Telephone Association.

During the 1903 legislative session, a bill was proposed that would have set maximum telephone rates based on population classifications: the larger the city, the higher the maximum rate. This type of legislation had been considered by previous legislatures, but none had passed. The independents believed that such a bill was financially harmful because it did not take into account the number of customers served in a particular city or the geographical area included in the exchange.(34)

Harper, who was the head of the Wisconsin Independent Telephone Association's committee on legislation, proposed a clever revision to the bill. Instead of establishing maximum rates based on population classifications, Harper proposed a bill providing that in all cities having approximately the same population, uniform rates for like service would have to be charged. The restriction only applied to telephone companies that served two or more cities of the same population classification. Harper's proposal was "very ingeniously drawn" because it would have had almost no impact on the independent companies. Most independents served only one city. The bill would have affected Wisconsin Telephone--the largest firm in the state. Bell served customers in over sixty cities and depending on local market conditions, could vary its price. But since most independents only served one city, the bill would leave them mostly unaffected by the legislation. On the other hand, the original maximum rate bill could have potentially affected all telephone companies.(35)

Harper's proposal was approved by the 1903 Wisconsin Assembly but was narrowly voted down in the senate.(36) The telephone price discrimination bill, unlike the pending railroad legislation, had received little attention in the press. The independents had four explanations for the defeat of the bill: a lack of active support by most of the independent companies; since the bill was entered late, it was not thoroughly understood; the association's refusal to pay five senators $2000 in order to secure their votes; and promises by a company to invest $500,000 in the state if the legislation was not passed. The independents believed that the firm that had made the investment proposition was a Wisconsin Telephone decoy.(37)

At the start of the 1905 legislative session, according to the Milwaukee Daily News, there was strong sentiment among legislators for some sort of telephone legislation. There was interest in empowering a commission to set the rates based on the cost-of-service. If there was not sufficient support for this type of legislation, the paper predicted that there would be action on an antiprice discrimination bill similar to the one that had been narrowly defeated in 1903. The 1905 legislature considered a bill that was almost identical to the one that had been defeated in 1903. The bill, which was introduced by Representative Donald, included sixteen population classes ranging in size from above 100,000 to the sixteenth class for population centers below 600. The association and others appeared before the legislature in support of the bill. The association told the assembly that the legislation was necessary in order to protect the independents from being crushed by their competitor, Wisconsin Telephone.(38)

The original bill considered by the legislature, while directed at Wisconsin Telephone, did affect thirty-six of the several hundred independent companies. Nevertheless, it was Bell that led the opposition to the bill. Bell argued that such legislation was unnecessary since there was no proof that it practiced price discrimination. While conceding that it had "in a number of instances, been forced by competition to cut the rates below the cost of giving service," it denied that it had raised its rates where it had no competition.(39)

Bell also pointed out to the legislature that variations in rates in cities of the same class were caused by other factors than just competition. Some of the factors identified by Bell were the number of phones in use in the exchange or the exchange calling area, the cost of hiring local labor, cost of installation, and other factors that caused differences in the cost of maintenance in the exchanges. These cost factors, according to Bell, were reflected not only in the variation in its own exchange rates, but in even greater price variations among the independents, rates for cities of the same class.(40)

Lastly, Wisconsin Telephone argued that the bill would reduce competition in the state. Bell believed that Harper's company, Dane County Telephone, was especially interested in seeing such legislation enacted because its market share was falling. Since it was not in Bell's financial interest to lower rates where it had a monopoly, if the legislation was approved, it would have to raise its rates where direct competition existed. Wisconsin Telephone predicted that in a city such as Madison, the price increase would eliminate competition.(41)

Wisconsin Telephone noted the paradox that effectively the independents were asking the legislature to limit competition, while a few years earlier when soliciting subscribers, the entrants had pointed out that competition was needed in order to reduce rates. During the discussion of the 1905 bill, Bell rhetorically inquired "Is not competition a thing to be desired?"(42)

Bell's public positions on the benefits of competition were not free of contradiction. In 1903 Wisconsin Telephone issued a pamphlet that was intended to discourage investors from placing their money in independent securities. Commenting on the disadvantages associated with the free market, the company wrote in its pamphlet Monopoly vs. Competition that:

Competition is undesirable, impracticable and unprofitable from every

point of view. Without a single redeeming feature, it only serves as an

incubus to any community, and to destroy the earning ability of the

existing companies.(43) But the response to its own question in 1905 was that

the promoters of this bill evidently do not believe that competition is a

good thing. In other words, the old maxim that "competition is the life

of trade" does not apply in these gentlemen's minds, to the telephone

business. They wish to be left free to raise their prices, or to be put in

a position where they can, and tie the Wisconsin company down to

certain rules in cities of the same class. The fact that the cities . . . are

benefited by the competition is not considered.(44)

While the arguments of Wisconsin Telephone were not persuasive in the eyes of the legislatures, the independents who requested changes in the bill were more successful. As stated above, as originally drafted, the bill would have had an impact on thirty-six of the independent companies. These adversely affected independents convinced the assembly to rewrite the bill. After refusing to pass the bill as originally introduced, by a vote of fifty-six ayes to twenty-nine noes, the assembly passed a bill that exempted the independents from the law. While the bill did not explicitly exempt Wisconsin Telephone's competitors, population classifications were redrawn so that the bill effectively only impacted Bell. This was achieved largely by changing the bill so that it only applied to towns with populations greater than 3000. Since many of the multiple exchange independents served smaller towns, this change in the legislation exempted them from its provisions.(45)

In the Wisconsin senate, the bill received the endorsement of the State Affairs Committee. Prior to the vote of the senate as a whole, Attorney General L.M. Sturdevant submitted, upon request, an opinion concerning the constitutionality of the law. Sturdevant did not believe that there were any constitutional problems with the bill since its purpose was "to prevent a monopoly in the telephone business." The attorney general went on to write that:

The provisions of the bill seem to violate no vested interest.... I am

unable to see that the classification made by the bill is unjust or unreasonable....

If in fact there is a wrong to be righted, then in my

opinion, there is nothing in the bill which makes it obnoxious to any

constitutional provision.(46)

Shortly after receiving the attorney general's opinion, the senate voted to refuse concurrence to the legislation by a vote of fourteen ayes to fifteen noes. The assembly, after receiving word of the senate's decision, returned the bill to the upper chamber requesting reconsideration. After voting down a proposed amendment that would have again extended the legislation to towns of less than 3000 citizens, the senate adopted the bill by a vote of thirteen ayes to eleven noes. Shortly thereafter Governor La Follette signed the bill into law.(47)

The vote reversal by the senate was the result of the strong lobbying efforts of La Follette. Beginning in 1904, the governor started to show a more active interest in telephone legislative issues. Apparently believing that political gains could be made by attacking Bell, and perhaps because of his continued financial interest in Dane County Telephone Company, La Follette let the senate know that he wanted the Donald bill passed. The governor and his aides succeeded in getting a senator to switch his vote. In exchange for the switch, the senator apparently received additional assurances that the governor would support a public projects bill pending before the legislature.(48)

A similar telephone pricing bill was introduced into at least one other legislature. Because of its potentially harmful impact, AT&T provided Wisconsin Telephone with considerable legal advice for its legal challenge to the legislation. While the bill was being considered by the state courts, Wisconsin Telephone apparently ignored its provisions. The one major court case brought under this law was delayed because of arguments over legal technicalities. Before the law was reviewed by the Wisconsin Supreme Court, it was replaced by the public utility statutes of 1907.(49)

Public utility regulation was proposed by Wisconsin Telephone as an alternative to competition. In 1906, the independents were close to obtaining a franchise in Milwaukee, and Bell realized that if a competitive exchange was established there, the incumbent's aggregate profits would "be down to nothing."(50)

Wisconsin Telephone argued before the Milwaukee City Council, and later in newspaper advertisements, that the community should be saved the financial burden and inconvenience of competition. To the surprise of many citizens of Milwaukee, Wisconsin Telephone offered a way of balancing customers, concerns with the financial interests of the company and the city:

The Company believes its rates are just, and all doubt can be removed

by calling in the aid of the state for the regulation of all telephone

prices, through the agency of a commission like the state railways rate

commission. The Wisconsin Telephone Company is ready to welcome

state regulation.(51)

This was the first time that a major telephone utility in Wisconsin advocated state regulation by a fully empowered commission. At the time the call was made, there was little public demand for state control of the telephone market. Wisconsin Telephone apparently took the lead in calling for state regulation because of its desire to protect its most profitable market, Milwaukee. In exchange for opening its books to state inspectors and for abiding by service standards established by a commission, the company expected protection from competition.(52)

The Wisconsin Public Utility Act of 1907 placed the telephone industry under the supervision of the Wisconsin Railroad Commission.(53) The law had a quick impact on the industry's market structure. In 1908, Dane County agreed to sell its properties to Wisconsin Telephone for $138,000, approximately $62,000 less than the firm said its stockholders had invested in the properties.(54) Wisconsin Telephone was able to acquire Dane County for less than cost because of Bell's strategy toward entrants: "[wear] them out and then [buy] them out."(55)

The president of Wisconsin Telephone informed the president of AT&T that the acquisition would provide four important benefits:(56)

1. Madison is the Capital of the state and it is worth a great deal to the Wisconsin Company to have competition removed from the view of the Legislature.

2. The President and active Manager of the Dane County Company [Harper] is the only strong man in the opposition forces in the state and in legislative matters he has been most powerful against us. He now retires from the telephone business and will assist us in legislative matters.

3. We have lost from $10,000 to $15,000 a year in Madison practically ever since opposition began.(57) Under the combination of the two properties we will stop this loss and will make a profit.

4. With the opposition in Madison cleaned up we will be able to effect mergers at other competing points and will be able to rapidly clear the state from competition.

Throughout areas where the independents did well, aggressively attacking entrants provided three important economic benefits to the incumbent. By maintaining operations in Madison, and other independent strongholds, the value of Bell service was increased in other exchanges. Customers were willing to pay a higher exchange rate to Bell for the option value of toll access to Madison. Also, Wisconsin Telephone Company's most profitable exchange was Milwaukee. Their return on investment in this city was approximately 10%, twice the cost of capital.(58) The independents were unable to enter this profitable market quickly because the Milwaukee City Counsel was reluctant to issue them a franchise. While attempts to enter had been made as early as 1895, a permit was not obtained until 1906. Even then, the independents were unable to raise the needed funds for construction.(59) If Wisconsin Telephone had not provided service to Madison, there would have been stronger support for a competitive exchange in Milwaukee from the business community.(60) Therefore, the losses in Madison helped protect the monopoly earnings in Milwaukee. Finally, because of Bell's aggressive response, Dane County Telephone's earnings were insufficient to finance large scale toll projects.

B. Predation in order to protect the value of the network

Dane County Telephone was a capable, well-regarded firm that was as competent as Wisconsin Telephone. The historical record from Wisconsin provides an interesting record for testing the efficacy of Areeda and Turner's criteria for predation. The industry was characterized by joint capital and a high ratio of fixed to marginal costs. At the turn of the century, the short run marginal cost of serving a customer was in the neighborhood of $.85 per month per line, well below both Bell's $2 and $3.50 reduced prices per month for residential and business service, respectively, and the average cost of production.(61) Furthermore, joint costs, though substantial, were fixed in the short run and ignored under the Areeda-Turner rule anyway. Therefore, if the Areeda-Turner test for predation was used to evaluate the conduct of Wisconsin Telephone, the firm would have likely been found innocent.(62)

Bell's aggressive response to entry was adopted elsewhere. New York City and Chicago were the two cities that independents were most interested in entering. In order to have a comprehensive toll system, it was essential that they have a terminus in these, the nation's leading cities. Furthermore, these monopoly markets were quite profitable. In 1903, operations in Chicago and New York City accounted for approximately 37% of the Bell Operating Companies, profits. City officials in New York and Chicago estimated that, in 1905, the return on Bell's investment in their cities was approximately 14.6% and 16% respectively.(63) In order to protect these markets, AT&T adopted the same response to competition in Illinois, Ohio, Indiana, and upstate New York, that had won it control in Wisconsin.(64)

AT&T's leaders clearly saw the strategic value of attacking entrants. Sunny, the president of AT&T's monopoly exchange in Chicago, pointed out that by taking losses at competitive points, rivals were unable to operate profitably. If the existing independents could not operate profitably, it would diminish their opportunity to expand into markets such as Chicago, or of internally raising money for their toll lines. Naturally, a poor return on existing investment would hurt the independents, ability to raise money from external sources. Sunny wrote AT&T's president that the losses at competitive exchanges in the Midwest were in the best interest of AT&T, because they would help "`exterminat[e]'" the leading Midwest Independent, United States Telephone, that was "`a menace to our whole organization.'"(65)

The history of the price wars in the telephone industry varies greatly from McGee's discussion of Standard Oil's pricing practices at the turn of the century. In McGee's seminal article on predation, he concluded that Standard Oil did not drive rivals out of business by initiating price wars, and that such predation would have been an irrational strategy for the firm to pursue.(66) He pointed out that by merging with its rival instead of cutting prices, Standard Oil could earn higher profits. Because predation involved an unneeded sacrifice of profits, merger was the preferred strategy. Theoretically, therefore, it seemed unlikely that dominant firms would pursue aggressive pricing strategies.

In the case of AT&T, the firm chose not to pursue the strategy proposed by McGee. AT&T's management realized that if it pursued the acquisition strategy suggested by McGee, the compensation provided to rivals would encourage future entry. The president of AT&T pointed out that by getting rivals to sell their properties for losses,

we discourage the man who sells it to us, so that he is less likely to

take the money we pay him to start another enterprise of the same kind

in an adjoining town; and moreover, we discourage others from going

into the business in view of their knowledge of the unsatisfactory

experience of those who sell to us at a loss. When we buy at a profit to

the seller, others must be encouraged to go into the business; if the

seller sacrifices something in selling to us, others must be discouraged.(67)

III. Conclusion

The history from Madison, Wisconsin illustrates that where a well-managed entrant has the ability to leverage its position in one market to enter other markets, the incumbent has a clear incentive to act in a predatory manner. In order to prevent a entrepreneur like Harper, who had strong political and managerial skills, from developing a network, Bell was willing to take long term losses in Madison. The reward to Bell was not so much in their opportunity to raise price after Dane County exited the market, but in the protection predation provided for Bell's remaining monopoly markets.

The Supreme Court has emphasized that predation is only sensible where there is a high likelihood that the initial losses will be exceeded by the future flow of discounted profits.(68) The history presented in this article illustrates that the measurement of future profits must include the profits of the crucial counterfactual, those profits that would have been foregone if not for successful predation. In the context of this article, the calculation must include the higher profits earned in places like Milwaukee, New York City, Chicago, and on AT&T's toll network, because of the predatory prices established in markets like Madison.

Easterbrook's analysis gives little consideration to factors such as joint costs and network externalities. It also implicitly assumes well-functioning markets. If the supply of people like Harper was infinitely elastic, Bell would have had less incentive to attack this particular entrant. But since visionary, capable leaders can be scarce, an incumbent has a clear incentive to attack competent entrants. Antitrust law should continue to be used as an instrument for protecting such firms. This will require the courts to continue to judiciously use a "rule-of-reason" standard to evaluate the merits of a complaint. Where the entrant can show that it is equally or more efficient than the incumbent, price reductions by the incumbent intended to be predatory should continue to be viewed as a section 2 violation of the Sherman Act. (*) Associate Professor, Department of Economics, Queens College, The City University of New York. (**) Associate Professor, Department of Economics, University of Nebraska, Lincoln, NE. (1) 475 U.S. 574 (1986). (2) See id. at 588. (3) See id. at 589-90. (4) Frank H. Easterbrook, Predatory Strategies and Counterstrategies, 48 U. Chi. L. Rev. 263 (1981). (5) Phillip Areeda & Donald F. Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 Harv. L. Rev. 697 (1975). (6) See, for example, William J. Baumol, Quasi-Permanence of Price Reduction. A Policy for Prevention of Predatory Pricing, 89 Yale L. J. 1 (1979); or Oliver Williamson, Predatory Pricing: A Strategic and Welfare Analysis, 87 Yale L. J. 284 (1977). (7) For a discussion, see Jean Tirole, The Theory of Industrial Organization 314--23 (1986). (8) See, for example, Joseph Farrell & Garth Saloner, Installed Base and Compatibility: Innovation, Product Preannouncements, and Predation, 76 Am. Econ. Rev. 940 (1986). (9) See, for example, Paul Milgrom & John Roberts, Predation, Reputation and Entry Deterrence, 27 J. Econ. Theory 280 (1982). (10) Panzar defines a joint good as an input "[t]hat is, once acquired for use in producing one good, they (sic) are costlessly available for use in the production of others." John C. Panzar, Technological Determinants of Firm and Industry Structure, in 1 Handbook of Industrial Organization 17 (Richard Schmalensee & Robert Willig (eds., 1989). By this criteria the loop used for local and toll was a joint good because there was no congestion on the line.

Prior to the start of the 20th century, Bell deployed separate loops for local and toll calls. Around 1892, AT&T ordered its operating companies to move all customers onto one network in order to achieve economies of scope. See, David Gabel, Divestiture, Spin-Offs, and Technological Change in the Telecommunications Industry--A Property Rights Analysis, 3 Harv. J. L. & Technology 75 (1990). (11) Jackson to French, January 16, 1897, box 1277, American Telephone and Telegraph Corporate Archive (hereafter AT&TCA) (quote); and Federal Communications Commission, Investigation of the Telephone Industry in the United States (Washington: U.S. Government Printing Office, 1939). (12) Harry MacMeal, The Story of Independent Telephony 24 (1934). (13) George Anderson, The Telephone Situation: Its Causes and Its Future, October 12, 1906, P. 67, AT&T; 3 Telephone Securities Weekly, May 2, 1908; and L.N. Whitney, Report on Conditions in Indiana, August 1907, at 21, box 11, Museum Of Independent Telephony. (14) Harper/Brester, May 12, 1899, Dane County Telephone Papers, Wisconsin State Historical Society (hereafter DCTP); United Telephone Voice, May 1921, Museum Of Independent Telephony. (15) David V. Mollenhoff, Madison: A History of the Formative Years 205 (Dubuque: Kendall/Hunt Publishing Company, 1982). (16) Wisconsin State Journal, December 31, 1895. (17) Id. at 3; see, also, Merrill Advocate, no date, cited in the Wisconsin State Journal, supra note 16; Dane County Telephone, To the Citizens of Madison: Statement Issued by Dane County `Telephone Company, circular received by the Wisconsin State Historical Society, September 19, 1906; and 16 Western Electrician, March 16 and March 30, 1895 at 138, 163. (18) Wisconsin State Journal, Madison Past and Present: 1852--1902 at 217-18 (Madison, Wisconsin State Journal, n.d.). (19) B.B. Clarke to Robert M. La Follette, August 30, 1895, DCTP; Mollenhoff, supra note 15, at 205; and Wisconsin State Journal, supra note 16, at 217-18. In Madison, Dane County Telephone served more customers than Wisconsin Telephone. Measured at the state level, Wisconsin Telephone was much larger. Bell served 9100 customers in the Badger State, 22 times more customers than Dane County Telephone. (20) DCTP, especially Harper to Frank Brewster, January 30, 1900; and Wisconsin State Journal, June 6, 1900. (21) Wisconsin State Journal, March 1896 (n.d.), quoted in Frank Custer, Ma Bell Calls on Madison: Are You There Charlie? 26 Madison Magazine, Feb. 1984, at 41--42; Wisconsin State Journal, December 31, 1895, at 3 and March 2, 1896, at 4; and Mollenhoff, supra note 15, at 205. (22) Wisconsin State Journal, March 2, 1896, at 4. (23) Wisconsin State Journal, December 11, 1895, at 1. Since the two systems were not interconnected, a consumer's decision about which system to subscribe to was affected by the choice of other citizens. There was little value in the free telephone service offered by Wisconsin Telephone unless many subscribers also chose to get service from Bell. Customers apparently believed that if many customers obtained service from Bell, it would destroy the entrant, and Bell would then raise its prices. Wisconsin State Journal, March 2, 1896, at 1. The customer's decisions are consistent with the Chicago school's proposition that predation may be ineffective if the subscribers refuse to cooperate with the predator. (24) J.C. Harper to F.E. Harvey, July 27, 1897, DCTP. (25) DCTP; and Harper to E.W. Delaney, May 29, 1899. By 1899, the company had increased the length of customer contracts to 5 years. Harper to Charles Webster, DCTP. Long-term contracts were used by other companies that competed with Bell companies. Oshkosh Daily Northwestern, February 3, 1900; and James B. Hoge, Secretary of United States Telephone Company to J.C. Harper, August 11, 1899, DCTP. (26) Clarke to J.C. Harper, June 2, 1900, DCTP. (27) Spooner to Fish, October 27, 1904, box 66, AT&TCA. (28) Harper/Chequamegon Telephone Company, January 17, 1899, DCTP; Wisconsin State Journal, supra note 18, at 217--18; and Allen/Pickernell, February 26, 1906, Allen Letter Books, AT&TCA. (29) Id. (30) Harper/Twining, May 29, 1899 and Harper/Davis, May 15, 1900, DCTP. Toll calls constituted approximately 1.3% of the calls made from Madison. The remaining 98.7% were local calls and the majority of these also were carried on the independent's network. Annual Reports of Telephone Companies (1910), Wisconsin State Historical Society, series 1337. (31) Wisconsin State Journal, March 2, 1896; and Harper/Gray, April 13, 1899 and Harper/Brewster, May 12, 1899, DCTP. (32) Arguments Against 263A, 1905, To Prevent Discrimination in Telephone Rates, Wisconsin Legislative Research Bureau; Burt to Vail, October 31, 1908, box 1163, AT&TCA. (33) Wisconsin State Journal, February 14, 1903. (34) Milwaukee Sentinel, February 13, 1903, and 32 Western Electrician, February 21, 1903, at 150. (35) Wisconsin State Journal, February 14, 1903 (quote). (36) Bill 603, A, 1903 Wisconsin Assembly Journal; Madison Democrat, May 20, 1903; and 34 Western Electrician, February 20, 1904, at 156. (37) 7 Telephony, March 1904, at 159--61; Electrical World, February 4, 1905, photocopy in Wisconsin Legislative Reference Bureau, file 384.1; 34 Western Electrician, Feb. 2, 1904, at 156; and O.N. Coon to La Follette, January 19,1905, La Follette Papers. (38) Milwaukee Daily News, January 26, 1905, quoted in Daily Telephone News, February 2, 1905; 1905 Wisconsin Assembly Journal, bill number 263A; and Milwaukee Free Press, March 23, 1905. (39) Wisconsin Telephone Company, A Discussion of Bill Number 263A. Introduced to the Wisconsin Legislature February 8th, 1905, at 2-3, 11, 13, Wisconsin Legislative Research Bureau. As a profit-maximizing firm, it is not surprising that the company's rates in city B would not be raised after rates were lowered in town A. Presumably, the rates in town B would have already been set at a level that would maximize profits subject to the constraints in the particular market. (40) See id. at 9, 11; Wisconsin Telephone Company, supra note 32, at 1, 4, Wisconsin Legislative Research Bureau. The company argued that the larger the number of customers served in a city, the greater the cost, and that this cost difference should be reflected in the rates. Milwaukee Daily News, May 23, 1905.

At the advent of the competitive era, Wisconsin Telephone used the number of stations in the exchange, modified to reflect the presence of competition, to determine customer rates. Minutes of Board of Directors, Wisconsin Telephone Company, March 5, 1895 and April 1895 (n.d.), AT&TCA.

By 1902, AT&T was advising Wisconsin Telephone to base its rates on the number of people living in a town--the same criteria used by Assemblyman Donald in the drafting of the antidiscrimination legislation. French to Burt, July 24, 1902 and Sherwin to French, July 18, 1902, General Manager Ledger Books, v. 639, AT&TCA.

Wisconsin Telephone also argued that the proposed legislation violated the Fourteenth Amendment of the United States Constitution since corporations providing service in the same towns under the same conditions received different protection under the law. That is, companies operating only one exchange in any given class of cities would not be affected by the law. Wisconsin Telephone Company, Discussion of Bill Number 263,A, Wisconsin Legislature, 1905, to Prevent Discrimination in Telephone Rates: Arguments on Constitutionality of "Bill," at 1-2, Wisconsin Legislative Research Bureau. (41) Wisconsin Telephone Company, supra note 39, at 5. (42) Id. (quote) (43) Wisconsin Telephone Company, Monopoly vs. Competition (1903), at 10, Wisconsin State Historical Society (hereafter WSHS). While concluding that the industry was "inherently" a monopoly, the company did not suggest that the monopolistic firm should be regulated. Id. at 12. (44) Wisconsin Telephone Company, supra note 39, at 7, 8-9. (45) 1905 Wisconsin Assembly Journal, at 1173, 1120, 1287; and Wisconsin Telephone Company, supra note 32, at l. (46) L. M. Sturdevant, Opinion of the Attorney General, 1905 Wisconsin Senate Journal, at 1350, 1353. (47) 1905 Wisconsin Senate Journal, at 1401, 1498, 1526--27; 1905 Wisconsin Assembly Journal, at 1913, 2133. (48) Fish to Burt, May 8, 1903, v.28, Presidential Letter Books, AT&TCA (hereafter PLB); Willet Spooner to Fish, October 27, 1904, box 66, and June 1, 1905, box 1037, AT&TCA; Burt to Fish, June 10, 1905, box 1037, AT&TCA; Milwaukee Journal, June 10, 1905. Spooner was a lobbyist for Wisconsin Telephone. (49) Fish to Burt, June 23, 1905, v.39, February 19, 1906, v.42, May 29, 1906, v.44, and October 27, 1906, v.45, PLB; Fish to Miller, Mack, and Fairchild, June 18, 1906, v.44, PLB; 9 Telephony, Jan. 1906, at 29; Dane County Telephone Company, supra note 17, at 1-2; 1907 Wisconsin Statutes, section 1797m-108, ch. 499; State of Wisconsin v. Wisconsin Telephone Company, 134 Wisconsin Reports 335 (1908); and George Miller to Russell Jackson, Deputy Attorney General, December 30, 1908, series 629, file 253, WSHS. (50) Fish/Burt, PLB, AT&TCA, July 29, 1905. (51) Milwaukee Journal, July 27, 1906; Wisconsin Telephone, Telephone Talks, WSHS, nos. 4,8, and 13 (quote). (52) Id. no. 4. (53) David Gabel, The Evolution of a Market: The Emergence of Regulation in the Telephone Industry of Wisconsin, 1893-1917, (unpublished Ph.D. dissertation, University of Wisconsin--Madison), at ch. 10. (54) The Democrat reported that the Dane County stockholders did not sell their stock out of fear for the company's long-term financial prospects. According to the newspaper, the "essential reason" for the sale was the stockholders, belief that regulation would provide sufficient price and service safeguards, and that a unified system would better serve the public.

The stockholders may have also been influenced by two other developments. The "home company" was quickly losing its large edge in the number of customers served. This may have been due to the public's increasing interest over time for long-distance connections, and because for a few months in 1904 Dane County Telephone's service, unlike Wisconsin Telephone, was seriously disrupted due to a winter storm. Furthermore, Bell was continuing to offer free or cheaper service, and there may have been some quality-of-service problems with the independent's lines. Willet Spooner to Frederick Fish, October 27 and December 30, 1904, box 66, AT&TCA; and Dane County Telephone, supra note 17.

Also, some of the heirs to some Dane County stock were interested in selling their stock. Burt to Fish, February 24, 1906, box 1163, AT&TCA. The independent had been unable to declare regular dividends. During its first 10 years of operation, it had only paid a total dividend of 9%. Instead, it reinvested most of its earnings for capital additions. By contrast, Bell managed to pay its stockholders a yearly dividend of from 6% to 8%, and could still afford to rebuild its entire plant in Madison between 1905 and 1907. Wisconsin Telephone's ability to finance the rebuilding of competitive exchanges from earnings in other markets gave it a great long-term strategic advantage over the atomistic, independent companies. Burt to Fish, February 24, 1906, box 1163, AT&TCA; MADISON Democrat, November 1, 1908; Telephony, March 27, 1909, at 374-75; and Annual Report of Wisconsin Telephone Company, June 30, 1910, series 1337, WSHS.

J.C. Harper did not believe that his company should have been sold to Wisconsin Telephone. Harper received support from one other stockholder. Together they controlled only 25% of Dane County Telephone's stock. Wisconsin State Journal, November 2, 1908.

The public apparently concurred with Dane County's stockholders that a regulated monopoly was the preferred market structure. Madison Democrat, November 3, 1908. Wisconsin State Journal, February 13, 1909. (55) Minutes of the Board of Directors of Wisconsin Telephone Company, November 12, 1908, AT&TCA, box 1372; and Testimony of Alonzo Burt, Frank Winter v. La Crosse Telephone and Wisconsin Telephone, Tr. 147 (quote), Wisconsin Railroad Commission, U-317, WSHS. (56) Burt/Vail, October 31, 1908, AT&TCA, box 1163. Burt added that by eliminating the popular and well-run competition in Madison, "we will be able to effect mergers at other competing points and will be able to rapidly clear the state from competition." (57) The reported loss most likely included an allowance for depreciation and therefore should not be viewed as evidence of pricing below the short-run, variable cost of production. (58) McLeod/Payne, April 1 and 28, 1899, AT&TCA, box 1060. (59) McLeod/French, October 28, 1895, AT&TCA, box 1298; and Daily Telephone News, June 4, 1908. (60) Milwaukee Free Press, July 27, 1906; Milwaukee Sentinel, July 27, 1906; and M.D. Atwater, The History of the Central Union Telephone Company, at 72-73, AT&TCA. (61) Gabel, supra note 53, at 90, 442. (62) Wisconsin Telephone did provide free telephone service to a small percent of its customers, and this was clearly a rate below the short-run marginal cost of service. But whereas the entrant served a majority of the city's customers, Areeda and Turner may have been willing to characterize this as a "`promotional' pricing" that should be available to the incumbent "in any market in which he lacks monopoly power." Areeda & Turner, supra note 5, at 733. (63) Hall/Fish, July 24, 1904, Operating Companies--Performance. Ratings--1903, AT&TCA, box 1348; Wall Street Journal, April 2, 1906; and Harry P. Nichols, Report of the Bureau of Franchises Upon the Application of the Atlantic Telephone Company, Oct. 12, 1905, AT&TCA, at 22. (64) David Gabel, Competition in a Network Industry: The Telephone Industry, 1894-1910, 54 J. Econ. Hist. 543 (1994). (65) Sunny/Vail, April 1, 1909, quoted in "Opinion Rendered by Judge William E. Dever," Slip Op. pp. 135-36; Read et al. v. Central Union Telephone Company, Superior Court of Cook County, Illinois, Chancery General # 299, 689; and Testimony of Frank F. Fowle, pp. 633-35, Read et al., above. (66) John S. McGee, Predatory Pricing: The Standard Oil Case, 1 J. L. & ECON. 137 (October 1958). (67) Fish/Pettegill, PLB, April 21, 1902, vol. 23, AT&T. Malcolm Burns has argued that in the tobacco industry, predation was an effective strategy because it lowered the cost of acquiring rivals. Predatory Pricing and the Acquisition Cost of Competitors, 94 J. Pol. Econ. 266 (1986). (68) Matsushita v. Zenith, 474 U.S. at 589.
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Title Annotation:Recent Competition Issues in Telecommunications
Author:Gabel, David; Rosenbaum, David I.
Publication:Antitrust Bulletin
Date:Sep 22, 1995
Words:9667
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