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Telecommunications policy and the persistence of the local exchange monopoly.

Telecommunications policy has never been without controversy. Yet since passage of the Telecommunications Act of 1996, debates that traditionally have been reserved for staid and often obscure public utility commission hearing rooms have spilled over to far more visible forums, such as state legislatures, editorial pages, and courtrooms. These debates center on the various rules and policies that will govern market structure and pricing throughout the telecommunications industry; the answers that emerge will have profound effects on the degree of consumer choice, prices, and quality of service across virtually the entire range of telecommunications services.

Given the increasingly vital role of information gathering, transmission, and dissemination for advances in productivity and competitiveness, these debates - which otherwise might be of interest to a relatively limited number of regulatory economists and telecommunications specialists - are taking on extraordinary and widespread importance for the broader economy. Indeed, it is probably safe to say that no sector of the U.S. economy will be unaffected by the outcome of this ongoing policy formulation process.

BACKGROUND

The modern era of telecommunications policy began with the divestiture of the Bell operating system in 1984. That divestiture was the culmination of a Department of Justice antitrust case that had been initiated in 1974. The widely accepted theory behind this case was that the long-distance portion of the telecommunications industry could, if separated from the monopolistic local exchange industry, realize effective competition. Consequently, this segment of the industry could then be deregulated.

The actual divestiture agreement, known as the Modification of Final Judgment, or MFJ, is a short but substantive document. Its principal requirement was the structural separation of AT&T from the regional Bell operating companies (RBOCs).(1) Upon separation, the former would provide inter-local access and transport areas (LATAs), long-distance services (both interstate and intrastate), while the latter would provide local exchange and relatively short-haul intraLATA long-distance services. The rationale for this structural separation was that the vertically integrated Bell system had both the incentive and wherewithal to disadvantage its fledgling rival long-distance firms through either outright denial or discriminatory provision of access to local exchange facilities whose control was exclusively in the hands of the Bell operating companies. Indeed, at the antitrust trial against the Bell system, substantial evidence was presented that the integrated Bell system had indeed acted upon these incentives to stifle the emergence of competition in the long-distance marketplace.(2) With ownership of the facilities of the local exchange monopoly (the Bell operating companies) separated from those of its former long-distance arm (AT&T), the former companies would no longer have any financial incentive to distort competition in the long-distance marketplace.(3)

Another key element of the MFJ was Judge Harold Greene's specification of the conditions under which the Bell operating companies could re-enter the interLATA long-distance marketplace. Specifically, section VIII(c) of the MFJ allowed for such Bell company reentry upon a showing that "there is no substantial possibility that it could use its monopoly power to impede competition in the market it seeks to enter."(4) Given this condition, reentry would be authorized upon a showing that the (upstream) local exchange market had become competitive. With competition at this stage of production, the ability to injure competition at the downstream stage vanishes and reintegration is warranted.

Industry structure, then, was governed under the MFJ from 1984 until the passage of the Telecommunications Act of 1996. This Act was the first substantive revision of the 1934 Federal Communications Act, which had first initiated federal government oversight of the telecommunications industry. This new legislation is not only a comprehensive revision to the 1934 Act, but it forges a completely new and bold path for telecommunications policy in the United States. Specifically, whereas in the past the principle aim of regulation might best be characterized as "protection" of incumbent utility providers of telecommunications from entrants and of consumers from the consequent monopoly power of the incumbent providers, the new Act seeks to promote competition in every telecommunications market. It does this by explicitly adopting policies that:

1. Remove legal and regulatory barriers to entry;

2. Allow for purchases of unbundled "elements" of the telecommunications network;

3. Establish pricing guideposts for the purchase of access to these unbundled network elements and wholesale services that are to be provided by incumbent local exchange carriers;

4. Require nondiscriminatory access to the operational support systems needed by entrants to process their customers' orders and render bills in an accurate and timely fashion.

Importantly, the Act continues, albeit in a modified form, the long-standing concern regarding the premature reintegration of the Bell operating companies into the interLATA long-distance market. The relevant provisions are contained in Section 271, which requires that, in order for the Bell operating companies to reenter the interexchange industry, they must first open their local exchange markets to competition.

Specifically, under the 271 provisions, an RBOC's reintegration within its certificated geographic territory is made contingent upon the satisfaction of four necessary preconditions:(5)

1. The RBOC must be able to demonstrate that it is providing interconnection to competitive local exchange providers (at least one of which is predominantly a facilities-based carrier) or, at the very least, that interconnection is generally available to potential competitors. Moreover, the terms and conditions under which the RBOC offers interconnection must conform to the standards established by a "competitive checklist" prescribed by the Act.

2. The RBOC seeking approval to reintegrate must comply with the Act's nondiscrimination and structural separation requirements. Importantly, the Federal Communications Commission (FCC) has interpreted these provisions to mean that not only must the RBOC refrain from discriminating among third parties, but regulators must also be able to establish that the RBOC does not discriminate between itself (or its subsidiaries) and third party providers.(6)

3. The Act requires the FCC to seek advice from the U.S. Department of Justice (DOJ) concerning each RBOC 271 application. In conducting its evaluation of these applications, the latter agency may apply any standard that it deems appropriate. Although the resulting DOJ recommendation is not binding on the FCC's decision, the Act requires that "substantial weight" be given to it.

4. The Act instructs the FCC to deny the application unless it finds that the requested reintegration is consistent with the "public interest." From an economic standpoint, such a determination would appear to require that the benefits accruing to telecommunications consumers exceed any potential harm to those consumers as a result of the proposed reintegration.

The above criteria are clearly intended to establish some threshold level of competition in local exchange markets as a prerequisite to RBOC reentry into long distance. The crucial question, then, is what that level of competition will be. Current policy requires that local exchange markets be "open to competition" before RBOC reintegration is allowed to occur. The issue reduces to how this rather amorphous phrase is defined. Currently, two markedly different definitions are being endorsed by opposing advocates.

One definition, championed by the RBOCs, is essentially legalistic in nature, with little or no economic content. This definition would classify a market as being open to competition when legal and regulatory barriers to entry have been removed and the fourteen-point checklist is at least superficially met. The other definition, endorsed by the interexchange carriers and other potential entrants, is more economic in nature. This definition would require that a sufficient amount of actual observed entry occur to demonstrate conclusively that: (1) Economic, as well as regulatory, barriers to entry have been lowered sufficiently to allow the threat of potential competition to exert a disciplining force on incumbent firm behavior; and (2) checklist items are being met in a functional as well as legal sense.

This latter definition presents a considerably more demanding standard for RBOC reentry. Nevertheless, it is this definition that must apply if the 271 provisions are to have economic content. And it is this definition that must apply to ensure that reintegration will, in fact, benefit consumers. Bell operating companies filed several applications for reintegration in 1997. Thus far, each of these applications has been denied. In denying the application of Ameritech Michigan, generally the RBOC acknowledged to be the most "procompetitive" in its approach to opening its local exchanges to competition, the FCC concluded that Ameritech had failed to demonstrate compliance with several of the 271 provisions.(7) The FCC similarly has denied the applications of SBC in Oklahoma and Bell South in South Carolina.

A key issue for the future of the industry structure is how the Bell operating companies react to the initial denials for their reentry into the interexchange market. One option would be for the RBOCs to "roll up their sleeves" and aggressively open their markets to competition sufficiently to satisfy the public policy standards articulated by the Act and the FCC and thereby to expedite their reentry into the interexchange marketplace.

Indications are, however, that the RBOCs have taken a distinctly different approach. Facing policy decisions that were not to their liking, the RBOCs have taken their case to a variety of different forums where they appear to be hopeful to find more sympathetic policymakers that they may convince to change the rules by which they are allowed to reintegrate. Specifically, the RBOCs have taken the FCC to court, have taken their case back to Congress, and have pressed editorial writers to take up their cause for reentry into the long-distance market.(8) At the time of this writing, it is unclear whether this approach will, in fact, expedite their entry into the long-distance market. It is apparent, however, that local exchange competition, once thought to be the first likely benefit of the Telecommunications Act, is instead turning out to be the first victim of the Act.

How have these public policy guideposts embodied in both the MFJ and the Telecommunications Act of 1996 affected the provision of long-distance and local exchange telecommunications services in the United States?

THE LONG-DISTANCE MARKET

While certainly not unanimous, a broad consensus appears to exist that public policy toward the long-distance industry in the past fifteen years has been a considerable success.(9) At least a partial contributor to that success was the conversion of local exchange company switches to provide competing long-distance carriers "equal access" to their customers' phones. Specifically, the MFJ required, inter alia, that local exchange companies provide such equal access to all interexchange companies that relied upon the local "bottleneck" facilities of the local exchange carrier to originate and terminate calls. As a practical matter, the introduction of equal access ended the dialing disparity that had required customers of long-distance companies other than AT&T to dial several extra digits to be able to place long-distance calls.

In the wake of the divestiture and the implementation of equal access, competition began to flourish in the long-distance market. At the time of the divestiture, AT&T was one of a handful of long-distance carriers, possessed roughly a 90 percent market share, had the only nationwide network, and the price of a coast-to-coast daytime long-distance call was approximately 55 cents a minute. By the end of 1997, the long-distance marketplace had changed dramatically. AT&T's market share of long-distance services had fallen to roughly 50 percent, with over 600 firms providing long-distance service in the United States.(10) With a modest amount of shopping, residential consumers typically find rates for long-distance services that now hover around ten cents a minute - an 82 percent decline from predivestiture prices.(11) In response to the growth of competition, essentially all states and the FCC have now ended price regulation of long-distance services.

In hindsight, it is possible to identify several key elements that were critical to the development of an effectively competitive long-distance marketplace. Foremost among these was the 1984 separation of ownership of the long-distance assets of AT&T from the bottleneck monopoly facilities of the Bell operating companies. Indeed, in spite of a variety of regulatory rules that were intended to prevent the discriminatory provision of local exchange access by the vertically integrated Bell System against its long-distance rivals, a number of industry analysts concluded that regulation, by itself, was essentially incapable of preventing the Bell companies from acting on their incentives to prevent competition in the long-distance market from developing.

Along with the structural separation, policymakers also undertook a number of specific actions that further enhanced the prospects for competition. As noted earlier, the implementation of equal access acted to reduce product differentiation barriers to entry that may have served to insulate AT&T's position in the long-distance market. Also, in virtually every state, regulatory entry requirements were eased so that legal barriers to entry were virtually eliminated. Finally, and importantly, policymakers conditioned the end of regulatory price controls on AT&T on a clear demonstration that effective competition in the provision of interexchange services had emerged.

The net effect of these policy actions has been an explosion of output, service offerings, and quality of long-distance services. At the same time, prices have dropped markedly, connoting the vigorous rivalry among the myriad long-distance competitors that are actively vying for the patronage of long-distance consumers. In sum, consumers have benefited tremendously from the introduction of competition and the subsequent deregulation of pricing in the long-distance marketplace.

LOCAL EXCHANGE TELECOMMUNICATIONS

In sharp contrast to the explosion of competition in the interexchange marketplace, competition has been much more elusive in the provision of local exchange services. In 1984, essentially all local exchange telephone services were provided by incumbent local exchange telephone companies (ILECs) that held franchised monopolies within their certificated regions. While some modest signs of change are beginning to emerge, the provision of local exchange service in 1998 is still almost exclusively provided by the incumbent local exchange telephone companies, in spite of the 1996 Act's elimination of regulatory barriers to entry.

There are several reasons why local exchange markets continue to remain so concentrated.(12) First, and most importantly, competitive entry into these markets requires an extremely high level of cooperation by the ILECs due to the technological necessity to interconnect competing networks. The Telecommunications Act of 1996 and FCC orders explicitly recognize this state of affairs. The Act places extensive and detailed obligations on the ILECs in the areas of sales of unbundled network elements, their pricing and provision, determination of wholesale discounts, conditions of interconnection, etc.

These obligations were written into this law because it is abundantly clear that competition in local services can only arise if the ILECs can be forced to refrain from a plethora of potentially anticompetitive practices. Unfortunately, competition in these markets is not in the ILECs' economic interest. Unsurprisingly, they wish to maintain their monopoly status over the local exchange. Potential entrants, then, are placed in the unenviable position of being forced to rely upon the cooperation of another party who has every incentive to be uncooperative. And regulators are placed in the equally unenviable position of trying to enforce that cooperation.

Cost conditions and investment requirements also severely limit entry into local exchange services markets, particularly on a facilities-based basis. Specifically, there are likely to be some portions of local exchange markets where natural monopoly conditions continue to prevail. Also, a substantial portion of local exchange investment appears to represent sunk costs that, of course, connote the lingering presence of economic barriers to entry. Moreover, the dominant position of the ILECs interacts with these cost conditions and investment requirements to discourage entry. In particular, the high capital cost requirements of facilities-based entry (virtually all of which are sunk) become particularly prohibitive if the ILEC can be expected to engage in strategic anticompetitive practices in the postentry period. Finally, if and to the extent that local exchange rates incorporate subsidies (funded by excessive access charges), entry is further discouraged. The level and nature of these subsidies, however, are uncertain at this time.

In summary, local telecommunications providers continue to possess considerable market power and maintain control over key elements of the telecommunications network upon which their prospective rivals must depend in order to compete successfully. And, perversely, the emergence of competition in the local exchange markets requires cooperation by the incumbent local exchange providers via reasonable and nondiscriminatory interconnection arrangements, efficient pricing and provisioning of unbundled network elements, wholesale services, and the like. Until sufficient facilities-based entry occurs to erode the dominant position the RBOCs now hold, these firms will continue to possess substantial monopoly power in both the access and local exchange services markets; at this point, it is unclear how long it will take for such entry to unfold.

Therefore, regulation has a critical and difficult role to play in facilitating competitive entry in these important markets. In the absence of some regulatory mechanism to oversee the practices of the ILECs, one cannot credibly expect that the elimination of regulatory barriers to entry by itself will produce entry sufficient to render these markets effectively competitive. There are clearly significant nonregulatory (economic) barriers to entry.(13) To fulfill the promise of competition in local exchange telecommunications markets, aggressive procompetitive policies are and will continue to be required.

Given the emergence of a policy specifically designed to enable a competitive supply of telecommunications services, one may reasonably ponder why it is that competition has not come to local exchange services. The answer springs from basic economics: firms with monopolistic control of a market are unlikely to cede that control willingly, and the strategies at their disposal to maintain control are virtually limitless. The past decade of policy debates over the introduction of competition in local exchange markets has been a poignant lesson in the difficulty of enticing a monopoly provider to open its markets meaningfully to competition absent (or even with) governmental intervention to do so.

PARALLELS BETWEEN TELECOMMUNICATIONS POLICY AND CHILD-REARING

In recent years, an approach toward the rearing of somewhat hard-to-control children has arisen under the moniker "Tough Love." Under such an approach to child rearing, children are not coddled, nor do parents (acting as rule-setters) acquiesce to the pleadings, pouting or tantrums of the child. Rather, the rule setter establishes a clear set of guideposts with well-defined rewards for compliance and no rewards, or punishment, for noncompliance to the rules. The theory behind this tough love philosophy is that, by establishing clear and nonnegotiable benchmarks for commendable behavior, a set of incentives will be put in place that lead children to behave in desired ways. Importantly, this approach recognizes that the parent cannot make the child behave in the desired fashion, but rather the desired behavior must emanate from the child. Only by putting in place a clear set of rules with appropriate rewards for desired behavior will the child be likely to exhibit the desired behavior.

Beginning in 1984, with the divestiture of AT&T and continuing through the more recent passage of the Telecommunications Act of 1996, telecommunications policy may aptly be described as one of "Tough Love." After decades of coddling to the demand of a vertically integrated monopoly supplier of telecommunications services for protection from emerging competition, telecommunication policy took a somewhat abrupt turn. Specifically, the divestiture of AT&T in 1984 split the monopolistic local exchange segment of the telecommunications industry from the potentially competitive long-distance segment.(14) A national commitment to promoting competition in the long-distance industry then emerged. And, importantly, the procompetitive policies that were adopted were not compromised or rescinded in response to subsequent pleadings by the affected firms.

More recently, policymakers have embraced the notion of developing competition in local exchange services. Akin to the "Tough Love" approach, to date, policymakers have generally eschewed direct micromanagement of the day-to-day affairs of telecommunications companies in their desire to promote competition. Similarly, policymakers have generally avoided coddling or acquiescing to the whining or tantrums of industry participants that are unhappy with the particular rules that have been established for promoting competition.

The commitment to a "Tough Love" approach to telecommunications policy, however, is presently under unprecedented attack. The RBOCs, which nominally embraced the Telecommunications Act, have now uniformly sought to have the Act and the regulatory rules implementing the Act overturned by whatever means possible. The RBOCs have complained bitterly to Congress, to state legislative bodies, to governors, to regulators, to courts, and to the media. The barrage of complaints will, no doubt, test the mettle of the national resolve to insist that real competition (with its substantial benefits) be the principal driver of our telecommunications policy.(15) Nonetheless, at this point it is unclear whether the "tough love" policy will continue and ultimately succeed or succumb to the clear interests of the local exchange carriers to sustain their monopoly positions.

FOOTNOTES

1 Under the MFJ, the territorial United States was partitioned into 161 Local Access and Transport Areas (LATAs). The RBOCs were granted authority to provide intraLATA calling while long-distance (interexchange) companies were granted authority to provide interLATA telecommunications. Over time, interexchange companies petitioned for and have been granted the authority to provide intraLATA toll calling as well. For details, see, Blank, Kaserman and Mayo (1998).

2 For a more detailed discussion of the antitrust case, see Temin (1987).

3 In general, input suppliers' profits are greater if output markets are competitive. See Spengler (1950).

4 See Modification of Final Judgment, United States of America v. Western Electric Company, Incorporated and American Telephone and Telegraph Company, Civil Action No. 82-0192 (with revisions as of January 1, 1989).

5 Reintegration into the provision of long-distance services outside the RBOC's certificated region is permitted immediately under the Act without any substantive preconditions.

6 First Report and Order, CC Docket 96-98, Federal Communications Commission, released August 8th 1988.

7 See In the Matter of Application of Ameritech Michigan pursuant to Section 271 of the Communications Act of 1934, as amended, to provide in-region interLATA Services in Michigan, Federal Communications Commission, CC Docket No. 97-137, adopted August 19, 1997, Para. 4.

8 Obviously, it is in the RBOC's interest to reenter the long-distance market with their local exchange monopoly intact. Indeed, one must ask why a rational firm would ever voluntarily relinquish a monopoly in one market in exchange for the right to enter a competitive market.

9 See Kaserman and Mayo (1994). For an opposing viewpoint, see MacAvoy (1996).

10 See Bender and Rangos (1997). For a more detailed discussion of the evolution of the long-distance market, see Kaserman and Mayo (1994).

11 Some, but by no means all, of this decline can be attributed to a substantial decrease in the access charges that interexchange carriers pay to local exchange companies for originating and terminating long-distance calls.

12 An alternative to the explanation we offer is that provided by the RBOCs. Specifically, they have argued that they have made their markets open to entry and that, in spite of this openness, the major interexchange companies have conspired not to enter the market. The presumed "reason" for this conspiracy is that, by doing so, the interexchange carriers are able effectively to forestall entry by the RBOCs into the long-distance market. A strong rebuttal to this "theory" is contained in Zeglis (1997).

13 Witness, for instance, the relative dearth of local exchange access provision captured by competitive access providers (CAPs), who, after a dozen years of extraordinarily high price-cost margins in these services, have been able to capture less than 2 percent of the market.

14 Technically, the divestiture only involved the divestiture of the Bell operating system, while the ability of GTE to participate in the long-distance business was guided by a separate consent decree.

15 Indeed, the RBOCs will certainly argue that the policies designed to insist on the opening of local exchange markets prior to their re-entry into the long distance markets is not one of "Tough Love" but is rather a case of "parental abuse."

REFERENCES

Beder, Joe and Katie Rangos, "Long Distance Market Shares: Second Quarter 1997," Industry Analysis Division, Common Carrier Bureau.

Blank, Larry, David L. Kaserman and John W. Mayo, "Dominant Firm Pricing with Competitive Entry and Regulation: The Case of IntraLATA Toll," mimeo, January 1998.

Dadd, C. Mark, "The Outlook for the Telecommunications Industry and the Implications for the Economy and Business," Business Economics, Vol. 33, January 1998, pp. 14-17.

Kaserman, David L. and Mayo, John W., "Long Distance Telecommunications: Expectations and Realizations in the Post-Divestiture Period," in Michael A. Crew, Ed., Incentive Regulation for Public Utilities, Kluwer Academic Publishers, Boston, 1994.

MacAvoy, Paul. W., The Failure of Antitrust and Regulation to Establish Competition in Long-Distance Telephone Services, Cambridge, Massachusetts, The MIT Press and the AEI Press, 1996.

Spengler, J.J., "Vertical Integration and Antitrust Policy," Journal of Political Economy, Vol. 58 (August 1950), pp. 347-352.

Temin, Peter, The Fall of the Bell System: A Study in Prices and Politics, Cambridge, UK, Cambridge University Press, 1987.

Zeglis, John, "Out of the Courts and Into the Market: Wouldn't it be Great?" Speech delivered at the American Enterprise Institute for Public Policy Research, December 18, 1997.

David L. Kaserman is Torchmark Professor of Economics, Auburn University, Auburn, AL. John W. Mayo is Professor of Economics, Georgetown University, Washington, DC.
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Date:Apr 1, 1998
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