-14-

dominant firm As the deregulatory plan unfolds, market performance could be
reevaluated to gauge whether further steps should be taken.25/

This paper suggests implementing gradual deregulation by removing the
rate of return contraint on AT&T's private line services (PLS). To implement
this objective, investment in Private line plant and equipment would be
removed from AT&T's interstate rate base. Other regulatory requirements,
however, would continue to apply to AT&T's private line services. Thus, AT&T

would still be required to file private line tariffs, although such tariffs

Ss

25/This gradualist approach to deregulation is similar to Markham's case-
by-caSé approach to workable competition. — Following Markham, a market is
“workably competitive” if there is Mo policy change that would lead to
significant improvement in market performance. See J. W. Markham, "An
Alternative Approach to the Concept of Workable Competition,” American
Economic Review 40 (June 1950):349-61. As argued in this paper, partial
deregulation of the PLS market ‘would provide incentives for improved market
performance, In recent years, pessimism concerning prescriptive welfare
judgments induced by Lipsey and Lancaster's theory of the "second best" has
given way to guarded opt imism. Increasingly, economists are willing to search
for welfare gains on a market-by-market basis, rather than establishing
rigorous criteria for global welfare gains over many markets. Reflective of
this approach is Arnold C. Harberger, "Three Basic Postulates for Applied
Welfare Economics: An Interpretive Essay, “Journal of Economic Literature 9
(September 1971):785-97. Applied "piecemeal” welfare economics depends
heavily, however, on the notion of consumers' surplus. Fortunately, Robert’
Willig has done much to improve the conceptual basis for making welfare
assessments based on this concept. See Robert D. Willig, Welfare Analysis of
Policies Affecting Prices and Products (New York: Garland Pub Tshing, Tnc.,
1979). Recent work by Williamson i}Tustrates the trend toward the piecemeal
approach for formulating wel fare- increasing policies. See, for example, 0. E.
Williamson, "Economies as an Anti-trust Defense: The Welfare Tradeoffs,"
American Economic Review 68 (March 1968) :18-36,



~35-

and business traffic.55/ By contrast, the demand for private line services
consists entirely of business traffic. In other words, the market for PLS is,
strictly speaking, a "wholesale” market where PLS is purchased not for final
consumption but as an “intermediate good" used in the production of the
business firm's output. On the other hand, MTS/WATS is a combined "retail"
and “wholesale” market where residence customers consume long distance toll
calls as final goods but business customers consume MTS/WATS as intermediate
goods.56/ Except for WATS, which is used by business firms with large
interstate message traffic, MTS business traffic is likely consumed by small
business firms that do not generate sufficient message volume to justify usage
of WATS or PLS, i.e., cost-effective bulk telecommunications services are not
as yet generally available for smaller business firms.

AT&T provides both MTS/WATS and PLS. Since AT&T is a multi-output firm,
the extent of AT&T's market- specific dominance in the MIS/WATS and PLS markets
is important in evaluating the performance of these markets. In some ways the
MTS/WATS and PLS markets are similar. Both markets have experienced entry in

recent years, especially following the Execunet II court decision.

55/In 1978, the percentage of business traffic of total interstate MTS
Messages was 45, 24% while residence traffic consisted of 53.6%. (1% consisted
of interstate pay station messages.) See American Telephone and Telegraph
Co., Bell System Statistical Manual, 1950-1978 (New York: American Telephone
and Telegraph Co., 1979), p. 005. There has been a slight tendency for the
percentage of residence message traffic to increase in recent years. Separate

revenue data for business and residence MTS are not conveniently available.
WATS is, of course, a business service.
\

56/The "retail-wholesale" market distinction has been suggested by Lee L.
Selwyn and William P. Montgomery, “Deregulation, Competition, and Regulatory
Response in the Telecommunications Industry," Public Utilities Fortnightly
(November 22, 1979):13-22. Selwyn and Montgomery, however, use the retaiT-
wholesale distinction somewhat differently than suggested here.



~31-

that the bulk of Bell System interstate PLS revenues are derived from point-
to-point dedicated telephone PLS, TELPAK, and, more recently, other telephone
grade private line service.50/

For the specialized common carriers (SCC) that now compete with the Bell
System in the PLS market, there is no statistical report directly comparable
to the Bell System Report No. 4. FCC Form P (Annual Report of Miscellaneous
Common Carriers) provides some data, however, that helps establish the
relative significance of SCC revenues vis a vis the Bell System. Table 3
provides total SCC revenues for the period 1975-1979 as reported by Form P.51/
52/. The second column of Table 4 shows total Scc revenues as reported in
Table 3 as a percentage of Bell System interstate PLS revenues reported in
Table 2. The third column shows the same computation including intrastate

Bell System PLS revenues. Both computations show the growth in SCC revenues

50/TELPAK is a “discount” private -line service intended for Targe-vol ume
communications between specified points. The service provides communication
Tinks for voice, data, facsimiJe, and signaling.

51/The service categories are those specified by Form P and are not
direttTy comparable to the interstate revenue categories in Monthly Report No.
4 for the Bell Systen as.reported in Table 2, The carriers included in the
determination of total SCC revenues in Table 3 vary somewhat over the period
1975-79 as new firms entered the industry. The carriers included in the
revenue compilation of Table 3 are MCI, Inc., MCI Telecommunications Company,
N-Triple-C, Inc., Southern Pacific Communications Co., Transportation
Microwave, Western Tel ecommunications, Inc., and Business
Telecommunications. While these finns do not exhaust the number of entities
in the SCC industry, the firms included generated the bulk of SCC industry
revenues over the period 1975-79,

52/Form P does not disaggregate SCC revenues by interstate and intrastate
jurisdictions. Also, the “Shared/Switched Voice Grade” revenue category
became quantitatively important after 1977. At present, Form P does not
require a separate reporting of MTS-like service revenues as distinct from
private line services that is fully comparable to the separation in Monthly
Report No. 4 for the Bell System.


-40-

would be expected to reflect cost more closely than MTS.68/

Concerning the extent of AT&T's market specific dominance in the MTS/WATS
and PLS markets, AT&T is clearly dominant at Present in the MTS market. Such
recent entrants as MCI, Southern Pacific, or SBS in the market for long

distance, switched message service are fringe competitors that have not to

68/Whether or not AT&T's private line tariffs reflect "cost" has been a
long-standing issue before the FCC. The issue became critical when AT&T filed
its first TELPAK tariff in 1961 as a competitive response to the FCC's Above
890 decision in Docket 11866. This Landmark decision allocated a portion of
the radio spectrum for private microwave systems that allowed users to provide
their own long distance telecomunication facilities, rather than relying
exclusively on AT&T's common carrier private line facilities. To determine
the lawfulness of the TELPAK tariff, the FCC conducted a number of extensive,
protracted proceedings culminating in the Docket 18128 decision in 1976 that
determined that fully distributed costs using "Method 7" would be the FCC's
standard for "legal costs." The specialized common carrier decision in 1971
Ted to further competitive PLS pricing responses by AT&T. In particul ar, AT&T
in 1973 filed proposed revisions to its PLS tariffs that departed from its
traditional policy of uniform nationwide rate averaging (the so called "Hi-Lo"
tariff). On October 4, 1979, the FCC terminated its most recent investigation
of AT&T's private line tariffs in. Docket 20814. In its Docket 20814 Final
Decision and Order, the FCC terminated further investigation of AT&T's Multi-
Scedule Private Line (MPL) tariff; prescribed an interim MPL costing
methodology pending the outcome of Docket 79-245 that will prescribe a cost
allocation manual for implementing the Docket 18128 decision; but did not
address PLS rate structure issues. From the "Seven Way Cost Study" ordered by
the FCC in 1964 in Docket 14650 through AT&T's most recent Central Submission
filed on June 30, 1980, private line services have earned rates of return
generally below the allowed rate of return and often substantially below the
rate of veturn for MIS. In terms of a fully distributed cost standard, such
low--sometimes actually negative--rates of return for certain private line
services imply tariffs that are actually "below cost". Of course, fully
distributed costs based: on historical accounting data need not necessarily
reflect economic opportunity costs that govern optimal decision making in
unregulated, competitive markets. Moreover, such "legal cost" notions are not
necessarily appropriate for formulating forward-looking deregulatory policies
for workably competitive markets.

ra
1,


The new literature on multi-output natural monopoly and sustainability
represents an important advance in economic theory. Its contemporary
relevance to regulatory policymaking in the telecommunications industry may be
limited, however. Sustainability theory in particular depends on simplifying
assumptions that are not totally descriptive of the telecommunications
industry. For example, sustainability theory typically assumes that potential
entrants use the same technology as the natural monopoly firm to produce the
same output. Firms that have entered the telecommunications industry in
recent years, however, have offered services differing somewhat in quality
from existing offerings and using somewhat different technol ogies.15/
Additionally, sustainability theory is generally static in character while the
impact of realized and potential market entry is inherently dynamic in
nature.16/ Apart fran these theoretical limitations of sustainability theory,

an empirical determination of cost function subadditivity is extremely

15/A theoretical study that considers the implications of open entry in a
rate base regulated monopoly industry but under somewhat different assumptions
than the sustainability literature is provided by Ronald R. Braeutigam, "The
Regulation of Multiproduct Firms: Dimensions of Entry and Rate Structure,"
Studies in Industry Economics No. 65, Stanford University, 1976.

16/For further discussion of the difficulties of applying sustainability
theory to real-world regulatory policymaking, see Vinson Snowerger,
"Sustainability Theory: Its Implications for Govermmental Preservation of a
Regulated Monopoly," The Quarterly Review of Economics and Business 18
(Winter 1978):81-89.



-50-

of anti-competitive Conduct may not be irrational, the Potential for such
predatory behavior May be more apparent than real, Unless the dominant firm
nolds a significant cost advantage over its rivals (which may simply reflect
economies of large-scale Operations), the effectiveness of predatory Pricing
is limited. it will be Successful only if the dominant firm can withstand
losses for a longer period of time than its Competitors and then recoup its
losses by raising price once its rivals have abandoned the fiarket. Since the
higher price will stimulate new entry in turn,” the practice of Predatory
pricing ultimately depends on an irrational response by competitive
firms.79/ If the dominant firm holds no cost advantage over its rivals, the
only promising predatory Strategy is to limit its own losses by restricting
price cuts to selective geographic markets or across a small number of
Products or services where it faces new Competition, This strategy may enable
the firm to exclude potential competitors in other markets without any
additional below-cost pricing. As stated by Richard Posner, "the- costs

_

73/The pathbreaking article by John McGee, "Predatory Price Cutting: The
Standard 071 (Node) Case," Journa? of Law and Economics j (October 1958) :137-
169, has influenced an extensive literature which now forms the “classic case"
against predatory pricing, More recently, economists and other antitrust
scholars have reopened the debate by demonstrating its rationality under
selected Circumstances. These include situations where the predator serves
many geographic markets, where efficient entry must take place on a large
scale relative to the size of the dominant firm, or where the dominant firm
Operates more efficiently than its competitors or potential competitors. for
a good summary of this literature, see George Hay, "A Confused Lawyer's Guide
to the Predatory Pricing Literature," unpublished paper. Predatory pricing in
selected geoghaphic markets is of most concern in PLS markets as none of the
other conditions appear to exist. Competitive Carriers have erected and

were removed, Moreover, to the extent economies of scale exist, applying a
Cost standard to AT&T's PLS tariffs will not yield a Satisfactory result for
the reasons discussed in the text below.


-48-

Vi. REGULATORY POLICY FOR A DEREGULATED PRIVATE LINE MARKET

Once the rate of return Constraint on the PLS market is removed, AT&T as
a dominant fim can be expected to pursue a pricing strategy that ‘max imi zes
expected profits over time. In general, a dominant firm, given its market
vower, can restrict output and thereby influence market price in the short
run. But if the market price exceeds the Tong run costs of production, the
competitive. fringe will expand and erode the market power of the dominant
Tirm.77/ The dominant firm is then faced with the trade-off of immediate for
long run profits. In designing an optimal pricing strategy the dominant firm
ust consider several factors including the extent of its cost advantage over
its rivals; the speed at which entry occurs in response to the gap between

price and long-run Cost; and the dominant firm's preference for present over

Sa

77/Aternatively, the analysis of the dominant firm can focus on “large-
scale entry" where the potential entrant must consider the effect of its
contribution to output on the market price of the good. In response, the
daninant firm can either maintain its level of Output and allow both firms!
profits to drain away as the price falls or reduce its output to keep prices
up and allow both firms to share the monopoly profits. The analysis of
“large-scale entry" is not determinative but simply depicts alternative
scenarios based on the assumption of the dominant firm's strategic behavior.

efficient scale without causing a significant drop in the market price. For
further discussion of these models, see Scherer, Industrial Market Structure
and Economic Performance, pp. 243-252,

ang economic Performance,



-54.

bundles of communications Services from different vendors .84/ AT&T would then
be unable to fragment markets or restrict price cuts to the markets served by
its competitors. AT&T's losses could then far exceed its competitors’ losses
from predatory pricing.

AT&T's PLS offerings will also be available to resellers, "Resale is the
subscription to communications services and facilities by one entity and the
reoffering of communictions services and facilities to the Public (with or
without adding “value") for Profit."85/ Tariff restrictions on the resale of
Some private line services are currently prohibited, and the FCC should extend
this prohibition to all private line services. Allowing carriers to broker or
arbitrage these services will further prevent AT&T from limiting its costs
fron predatory Pricing.86/ PLS offerings could then be broken dow in many
Ways and resold to a variety of customers who otherwise would not shop in PLS
markets. For example, a private line of sufficient bandwidth could be broken
down by multiplexing, or any Private line could be resold for different time
periods. AT&T's private line facilities could also be resold to MTS
customers thereby challenging AT&T's dominance of this market. Should AT&T
attempt to pursue a Predatory pricing strategy, these forms of resale will
impose costs on AT&T that its PLS competitors will not have to bear.

Sn

84/The FCC in its recent “Computer II" decision has ordered AT&T to
“unbundle” its tariffs for transmission services and customer premises
equipment (CPE). A discussion of how unbundling improves economic efficiency
in consumption is Provided in the Docket 20828 (Second Computer Inquiry) Final
Decision adopted April 7, 1980, pp. 63-70.

85/Resale and Shared Use_of Common Carrier Services, 60 FCC 2q 261

(1976).

86/Enchanced service carriers that add valuable information handling to
basic communications services also depend on resale to serve the public
effectively. .



~58-

constraint on PLS. Should AT&T pursue a predatory pricing strategy despite
the financial losses that unrestricted resale will generate, the FCC can
impose an price rule that would penalize the predator while not simultaneously
encouraging the inefficient allocation of resources that rate base regulation

implies.


-46-

regulatory tool that can detect and thereby constrain gross, unjustified cast
allocations by AT&T.75/ Under the Proposal of this paper, the allocation of
Jointly-used plant and equipment between MTS/WATS and PLS would still be
required in accordance with Docket 79-245. The Portion of plant and equi pment
Jointly-used with MTS/WATS as well as the directly assignable investment in
PLS plant and equipment would be removed, however, from AT&T's interstate rate
base. PLS tariffs would no longer require "cost justification" in terms of
reported accounting costs.

While AT&T still retains the incentive to’ shift of PLS costs onto the
MTS/WATS ratepayer under this regulatory treatment, the only constraint that
can be effective against this Practice is the cost allocation procedure. Once
this "cost-cut" is made in terms of the procedures Prescribed in the Docket
79-245 cost allocation manual » MIS/WATS tariffs will not be allowed to recover
PLS reported costs, regardless of the regulatory policy toward PLS markets.
Further, to the extent shortcomings in-or an evasion of the cost manual allow
AT&T to cross-subsidize private line services, reported costs on PLS will fall
short of actual costs. But it is the reported costs upon which tariffs must
be based, and in this circumstance AT&T's competitors would not be protected

by rate base regulation. In fact, binding rate of return regulation would

ee

75/In the unlikely event that the FCC's cost allocation procedure imposes
too few costs on the MTS ratepayer, removal of RBR including “cost-based"
tariff justification from PLS markets would allow AT&T to price private line
services below their reported cost and closer to short run marginal costs. In
the long run, however, the distortion will lead to the inefficient provision
of this service if planning and investment decisions continue to be based on
the distorted cost allocation.


-18-

marginal cost of Production and thereby restrict output to socially-
inefficient levels. As the number of firms in a given market increases from
one to "many" similar-sized entities, the monopoly power of a single seller is
diluted, output approaches social ly-efficient levels, and market price falls
toward the marginal cost of production.31/ The behavior of real-world markets

falls somewhere along a continuum between these polar cases.

as

31/More precisely, it is not simply the increased numbers of firms that
improve market performance. With the exception of the Cournot model that
directly links the number of firms in an industry to competitive market
performance, assumptions concerning the nature and extent of firm
interdependence in decision-making affect performance in a given market. The
literature on oligopoly models shows clearly how different behavioral
assumptions concerning firm reactions to rival's pricing and output policies
influence market outcomes. In particular, models of market behavior based on
game theory are beginning to receive emphasis in the applied rather than just
in the theoretical literature. See, for example, Leslie Hannah and J. A. Kay,
" Concentration in Modern Industry (London: Macmillan Press Ltd., 1977). The
analysis of probable ATaT pricing behavior of PLS following deregulation is
considered later jin this paper and explicitly considers the role of dominant
fim behavior vis & vis fringe competitors.



~36-

Furthermore, both markets may, in Panzar's analysis, be contestable.
Moreover, AT&T has not shown conclusively that it is a natural monopoly in the
production of both MTS/WATS and PLS.57/

But the demand-side differences between the MIS/WATS and PLS markets that
must be considered in an assessment of AT&T's market-specific dominance imply
differing levels of performance as well as the need for differing regulatory
policies for each market. Concerning demand-side differences, MTS, as a
retail market, presently has few close substitute services, especially for
customers with relatively small message volumes .58/ At present, the typical
household that makes less than $25 worth of long distance calls per month has
few alternatives to MTS provided by AT&T.59/ Much the same is true for the

small business user of MTS. Consequently, until further competition develops,

57/As discussed in Section II, the modern view of natural monopoly would
require that AT&T demonstrate that its multiple-output cost function is
"subadditive." The conceptual and empirical difficulties of testing for
Subadditivity are substantial however. The Second Report in Docket 20003
noted that the “market test" of apen entry would provide a useful test of
natural monopoly as an alternative to formulating entry policy in the
telecommunications industry based on the untested hypothesis of potential cost
function subadditivity. See Second Report in the Matter of Economic
Implications and Interrelationships Arising From Policies and Practices

Relating to Customer Interconnection, Jurisdictional Separations and Rate
Structure, FCC Docket 20003, Released January 29, 1980, p. 54.

58/Recent econometric models of MTS demand developed by Alex Belinfante
of the Common Carrier Bureau of the FCC suggest that the demand for short haul
MTS tends to be somewhat price inelastic while long haul MTS appears somewhat
price elastic. These results, however, are only preliminary and continuing
research is in progress. For some discussion of current FCC econometric
demand modeling of MIS, see Alexander Belinfante, "Modeling Point-to-Point

Long Distance Telephone Demand," a paper presented at the annual meeting of
the Anerican Statistical.Association, Houston, Texas, August 11, 1980.

59/MCI currently advertises that households making more than $25 worth of
long “distance telephone calls per month in an MCI service area can save
considerably by using MCI's off-peak, long distance telephone service.


I.

Il.

Il.

Iv.
ve

Vi.

VII.

Table of Contents

INtrodUuCt iON. seccecscccevccvscoscessesores

Rate Base Regulation and Economic EFFICIENCY. cecerecceceees

A. Closed-Entry Models of Sing] e-Out put
Natural Monopolyss.eees Prrerere er Terre ters
B. Open-Entry Models of Mu j-Output Natural
MOMOpOLYsesccccccvcnscescncccsecsssccccseseseres
C. Deregulation as an Alternative to Rate Base

Regul ationsscceesecccvevsscccssescssscersseessees seer e®

The Doninant Firm and Market Performance sececeseeseoererres

A. The Concept of Market-Specific Dominance.
B. The Application of Market-Specific Dominanc
to Transitional Telecommunications MarketSeccsccccceses

ee eecceeves

The Markets for MTS/WATS and PLS.esseceeesececerecscrcccees
The Problem of Inter-Service Cross-SubsidizatiOnesseececoee

Regulatory Policy for a Deregulated Private Line
Market.

sovccccccccecncsscsessssscccscesceseessscere eee

Concluding ObservationS..cccccececccsececcesesererrreresee®

Page

24
28

48
57


-29-

TABLE 1

TOTAL BELL SYSTEM INTERSTATE DOMESTIC MTS, WATS, AND TOLL PLS REVENUES,

1972-1979
($000)

Year MTS _ WATS PLS

1972 4,974,274 $37,009 812,148
1973 5,719,227 687,149 863,305
1974 6,198,526 835,059 889,773
1975 6,875,350 1,016,915 957,006
1976 7,698, 500 1,324,271 1,026,186
1977 8,480,751 1,644,891 1,079,234
1978 9,629,651 1,961,783 1,224,080
1979 10,827,411 . 2,254,521 1,396,398

SOURCE: Monthly Report No. 4 (Bell System Operating Revenues) filed
with the FCC.


-~15-

would not require cost support justi ficetion.26/ In a newly deregulated
market, tariffs will provide an important information function that will help
prevent anti-competitive price discrimination or discriminatory access to
facilities. Applications to build new plants as presently required by Section
214 of the Communications Act of 1934 would also be required.27/ In short,
onty the rate-of-return constraint on private line services would be
relaxed;28/ other common carrier regulatory practices would continue for the
present. By contrast, MTS/WATS would continue to be regulated consistent with
Title II of the Communications Act of 1934. The performance of the PLS market

would be "monitored" by the FCC subsequent to the removal of the rate-of-

ee

26/Such tariffs should be simplified, consistent, and unbundled. The
revision of AT&T's private line tariffs is presently the subject of CC Docket
79-246. See Notice of Inquiry and Proposed Rulemaking in the Matter of AT&T
Private Line Rate Structure and Volume Discount ractices released October WV,

1979.

27/Aithough investment allocated to interstate PLS would be removed from
AT&T's interstate rate base, retention of Section 214 authority over capacity-
expanding investment would facilitate the detection of possible PLS "predatory
investment" by AT&T. This point is discussed in more detai? in the following
sections of the paper.

28/A_ major simplification in the cost justification of private line
services is proposed in CC Docket 79-245. See Notice of Proposed Rulemaking
in the Matter of AT&T Manual and Procedures for the ocation of Costs
released June 26, 1980. This Notice proposes to require only that the

aggregate of all private line service earn the allowed rate of return.



-21-

directly affected.36/ From the consumer's viewpoint, it is market performance
rather than market structure per se that matters.37/ While in general more
competitive market structures may imply better market performance, the

relationship between structure and performance is often complex and

ee

36/For example, the general industrial organization literature on pricing
behavior in oligopoly markets frequently hypothesizes that the excess of price
over cost is a direct function of the degree of concentration. For example,
Cowling and Waterson derive the static relationship (px - = 4X 4)/px = H/u
where px measures aggregate industry revenues; C4Xy measures total cost for
firm i; H represents the Herfindahl index of concentration; and measures the
market elasticity of demand. Assuming a homogeneous product and an oligopoly
market structure, the Cowl ing-Waterson relationship shows that the average
price-cost margin in the industry is positively and directly related to the
extent of industry concentration as measured by H (where its reciprocal may be
conceived as measuring the equivalent number of equal-sized firms in the
industry) and inversely proportional to the elasticity of market demand, U .
For further discussion, see K. G. Cowling and M. Waterson, "Price-cost Margins
and Market Structure," Economica 43 (1976):267-74 or the brief discussion in
Hannah and Kay, Concentration “in Modern Industry, Chapter 2. Of course,
admitting the possibility of differentiated products, the role of collusive
and other strategic behavior, as well as the possible behavioral differences
between a doninant and oligopoly firm weakens the relevance of static price-
cost/concentration relationships to the regulatory analysis of this paper.
Pricing issues as they relate to the regulatory reform proposed in this paper
are discussed in Section VI. °

- 37/The industrial organization literature is often characterized in terms
of a “structuralist" vs. “behaviorist” viewpoints. The structuralist approach
emphasizes direct empirical links between market structure and performance
while the behaviorist approach emphasizes the importance of intervening
conduct variables as well as structural variables in explaining market
performance. The work of Joe S. Bain is usually cited as reflecting the
structural ist viewpoint. See Joe S. Bain, Industrial Organization (New
York: John Wiley, 1959). The behaviorist or so-called neo-Chicago school”
viewpoint is clearly reflected in George J. Stigler, The Organization of
Industry (Homewood, Illinois: Richard D. Irwin, 1968). The work of F. M.
Scherer, Op. Cite, while eclectic in approach nevertheless reflects a
behaviorist orientation. This paper reflects more a behaviorist than a
structural ist orientation. Regardless how the viewpoint of this paper may be
characterized, the emphasis for policy purposes is on market outcomes rather
than the possible causal or environmental factors at work. If market
performance is acceptable, then neither conduct regulation nor structural
changes are required from a public policy viewpoint.


-17-

The thrust of this modest deregulatory proposal seeks to eliminate both
the static and dynamic economic inefficiencies that rate of return regulation
may induce.30/ The administrative costs of rate base regulation as it
pertains to AT&T's private line services would also be reduced. Moreover,
rate base regulation could no longer serve to protect AT&T's PLS competitors
if in fact they operate less efficiently than AT&T. In short, the
deregul atory proposal of this paper would promote economic efficiency in the
private Tine services market, reduce the cost of regulation, and provide a
profit incentive for accelerated innovation in private line services.

Ill. THE DOMINANT FIRM AND MARKET PERFORMANCE

Few real-world markets literally consist of either a single firm supplier
(a monopoly) or so smany firms that no single producer individually can
influence market price (pure competition). The market models of monopoly and
pure competition are essentially theoretical polar cases that sharply focus
attention on the conditions that influence market performance. Thus, a single

seller of a single output can establish a market price in excess of the

ee

30/Constraining a profit-maximizing firm to earn a rate of return no
greater than the firm's financial cost of capital may discourage the risk-
taking that accompanies innovative behavior. With no financial incentive in
the form of supranormal profits to spur innovation, the regulated firm may
pursue rel atively risk-averse investment strategies that delay the adoption of
product and process innovations. See, for example, the discussion in William
G. Shepherd, "The Competitive Margin in Communications” in Technological
Change _in\ Regulated Industries, ed. William M. Capron (Washington, D. The
Brookings institution, O71), pp» 117-118. While “regulatory lag" may p' ‘ovide
some stimulus to risk-taking by permitting the rate of return to exceed the
cost of capital for awhile, this incentive may be rel atively ineffectual if
inflation pushes the regulated firm's financial cost of capital above the
allowed rate of return for extended periods of time.


~30-

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-12-

consumer choice.22/ Over the past decade the deregulatory policies of the FCC
favoring open entry and competition in selected telecommunications markets

have provided substantial consumer benefits while having little adverse effect

22/Some recent contributions to the literature on imperfect competition
suggest that equilibrium in open entry markets with profit-maximizing firms
represents a market-determined compromise among the extent of product
diversity available to consumers, product price, and the realization of
economies of scale. Moreover, this market-determined compromise may be shown
to be inferior to a welfare optimun measured. in terms of total consumer and
producer surpluses. See, for example, Michael Spence, "Product Selection,
Fixed Costs, and Monopolistic Competition,” Review of Econanic Studies 43
(1976):217-235. From such analysis an argument for regulation of market
behavior and structure might be made. The experience gained during the 1960's
and 1970's concerning government intereference in markets to correct for
“market failure” has prompted, however, a re-examination of the efficacy of
such governnent policies. In other words, the alternative to market failure--
government interference--may be the greater of two evils. Some writers now
argue that "government failure" in attempting to correct for market failure
often produces a greater social problen than the welfare losses resulting from
deficiencies in the functioning of particular markets. See, for example, the
provocative discussion by Roland Vaubel, “Repairing Capitalism,” Regulation:
AEI Journal on Government and Society 4 (July/August 1980):12-16. Moreover,
some economists argue that "monopoly bureaucracies" established to deal with
particular-instances of market failure have an incentive to produce excessive,
non-optimal levels of government service, i.e., the social mechanism for
correction of the market mechanism may itself be inherently wasteful. See the
analysis developed by William A. Niskanen, Jr., Bureaucracy and Representative
Government (Chicago: Aldine-Atherton, 1971). Apart from socially non-optimal
bureaucratic incentives, regulatory agencies in particular face enormous
political and informational difficulties in the administration of regulatory
processes. Given these inherent difficulties, it is not surprising that
regulatory intervention in markets is costly. For a recent discussion of
regulatory costs and estimates of such costs, see Murray L. Weidenbaum,
"Governnent-Mandated Inflation" in Economic Effects of Government-Mandated
Costs, ed. Robert F. Lanzillotti (Gainesville, Florida: University Presses of
Florida, 1978), pp. 3-22. The net increase in consumer welfare after imposing
regulation and deducting its costs may be negative. Both the lessons of
recent experience as well as contemporary economic analysis suggest that the
social decision to intervene in markets should carefully consider the full,
long-term consequences of possible government failure that may be the
unfortunate outcome of well-intentioned social policy.



-56-

below cost fs only the first stage of predatory behavior (and not in itself
harmful to consumers); the second stage occurs only if competitors are forced
out, and the predator is free to set price above cost and reap excess
profits. The "Baumol Rule” is designed to prohibit the second stage and
thereby undermine the entire practice of predatory pricing.88/ The Baumol
Rule would prohibit the dominant firm's withdrawal of recently lowered prices
upon the cessation of its competitors’ operations. While the fim would be
allowed to raise prices to cover increased costs (not under its control), it
would not be free to change price in response to changes "in the state of
competition in the market."89/ While application of this rule depends,
unfortunately, on cost data (to Support a later price increase), the.threat of
its application by a regulatory agency may be sufficient to deter predatory
conduct. The drawback of relying on a rule that restricts a firm's pricing
freedom must be considered and weighed against the need for a pricing rule in

light of the power of regulatory tools previously discussed. 90/

88/William J. Baumol, “Quasi-Permanence of Price Reduction: A Policy for
Prevention of Predatory Pricing,” Yale Law Journal 89 (November 1979):1-26.

89/Ibid., p. 1. .
90/Joskow and Klevorick, op. cit., also point out that the Baumol rule

may not deter a dominant firm from retaining a price below cost in a selected
market as a deterent to entry in other markets.


-4-

of output. 5/ V. Kerry Smith suggests that regulation may distort the optim al direction
of technological change_6/, while Roger Sherman and Michael Visscher show that
regulation may encorage price structures that do not maximize consumer welfare. 7/
Additionally, Elizabeth Bailey and Lawrence White demonstrate that rate of return
regulation may promote pricing that both accentuates peak demand and
encourages investment in peak capacity that is greater than socially optim al.8/

In general, these studies of regulation-indeed distortions are developed
in terms of static and comparative-static models. 9/ Dynamic analyses of the
same regulatory problen sometimes qualify the unambiguous conclusions derived
in terms of static economic models. for example, a dynamic Averch-Johnson

model developed by Alvin Klevorick shows that the ". . . direction of the

5/Charles We Needy, Regulation-Induced Distortions (Lexington, Mass.:
Q. C. Heath and Co., Lexington Books, 1975).

S/V. Kerry Smith, "The Implication of Regulation for Induced Technical
Change," The Bell Journal of Economics and Management Science 5 (Aut unn
1974 ):623-32.

J/Roger Sherman and Michael L. Visscher, "Rate-of-Regulation and Price
Structure” in Problems in Public Utility Economics and Regulation, ed. Michael
A. Crew (Lexington, Mass.: De Ce Heath and Co., Lexington Books, 1979), pp.
119-132.

B/Elizabeth £, Bailey and Lawrence J. White, "Reversals in Peak and

Offpeak Prices," The Bell Journal of Economics and Management Science 5
(Spring 1974):75-95.

9/A rigorous, treatise-length discussion of various aspects of the
effects of rate base regulation in terms of statics and comparative statics is
provided by Elizabeth £. Bailey, Economic Theory of Regulatory Constraint
(Lexington, Mass.: D. C. Heath and Co., 1973).



-27-

Panzar's notion of contestable markets implies that entry will tend to be
excessive rather than insufficient.46/ In short, assessing the extent of
market-specific dominance must recognize both the influence of existing as
well as potential entrants in the market.

In brief, the concept of market-specific dominance as a conceptual
framework for evaluating market performance recognizes the multi-output
character of most real-world firms; emphasizes the importance of potential
entrants as a dynamic influence affecting firm conduct; and explicitly
recognizes the importance of structural characteristics of market demand as
factors influencing market performance. The concept of market-specific
doninance focuses attention on the performance of a dominant firm in a
particular market and de~emphasizes the public policy consequences of supply-
side, firmspecific dominance as viewed in the aggregate over all markets
served by the firm. As an approach to regulatory policy, market-specific
dominance stresses the importance of performance in individual markets served
by the firm rather than the firm per se as the focal point of regulatory

policy-making.

46/Ibid., p. 314.


-24-

B. The Application of Market-Specific Dominance to Transitional

Tecommunications Markets

To make the notion of market-specific dominance operational requires a
working definition of a market for a particular good or service. Developing
such a working definition may be difficult. Indeed,-much of the anti-trust
literature on mergers hinges on defining relevant markets.41/ Nevertheless,
economic theory provides useful guidelines for defining the boundaries of
real-world markets. For example, Joan Robinson's theoretical notion of an
industry as a group of firms producing a single commodity ". . . where a
commodity in the real world is bounded on all sides by a marked gap between
itself: and its closest substitutes. . ."42/ captures the essential idea of a
well-defined market for a particular commodity.

Applying Robinson's notion of an industry to real-world markets is
extremely difficult, however. More recently, some economic theorists have
begun to enphasize the properties of goods rather than consumer preferences as
the appropriate conceptual foundation for consumer demand.43/ This more
recent approach seems especially -helpful in defining market boundaries for

technical services such as private line communications that possess specific,

41/For further discussion, see Scherer, Industrial Market Structure and
Econanic Performance, Chapter 20.

42/Joan Robinson, .The £conomics of Imperfect Competition (London:
Macnillan, 1933), p. 17.

43fKelvin Lancaster has emphasized this approach in recent years,
although the genesis of such thought can be traced to Menger and Chamberlin
and applied in the 1950's by Theil, Houthakker, and others. See Kelvin J.
Lancaster, "A New Approach to Consumer Theory," Journal of Political Economy
74 (April 1966):132-57. A complete exposition is given by Kelvin Lancaster,
Consumer Demand: A New Approach (New York: Columbia University Press, 1971).



I. INTRODUCTION

The 1980's will be a decade of transitional change for the domestic
telecom unications industry. As a result of Federal Com munications Com mission (FCC)
policies of the last dozen years, former monopoly interstate telecom munications markets
have been opened to firms wishing to énter the industry. This openentry market
environment has forced the re-examination of federal regulation of the
telecom munications industry. In particular, the continued application of Title IT of the
Communications Act of 1934 to all telecommunications firms of the 1980's raises
difficult questions of equity and efficiency in a dynamic, operrentry industry. Until
modern com munications legislation is finally enacted, regulators must wrestle with the
problem of applying regulation designed for monopoly markets to an industry that
consists today of numerous Jarge and small firms differing in both organization and
technology from tradition al telephone and telegraph companies.

This paper presents a regulatory proposal for transitional telecom munications
markets with emphasis on AT&T's private line service (PLS) market. This paper assumes
the continuation of the FCC's open-entry policies and attempts to deal with the role of
rate of return regulation in a in arket environment that wil become increasingly
com petitive during the 1980's. Section Il of the paper briefly reviews some of the
conceptual difficulties with rate of return or rate base regulation as discussed in the
recent academic literature. Additionally, the rem oval of the rate of return constraint on
AT&T's private line services is proposed as a way to avoid the possible economic
distortions induced by rate base regulation, reduce the direct and indirect costs of
regulation, and generally improve performance in the market for private line

telecom munications services.




-13-

on the established firms in the telecommunications industry .23/

As the telecommunications industry evolves toward a more competitive
market structure, the continuation and uncritical acceptance of rate of return
regulation of dominant firms in the industry should be reconsidered. One
approach to the problems associated with rate base regulation of dominant
firms is to eliminate regulation in one "Fl ash-cut ."24/ White enactment of
this policy may reduce some of the transition costs in achieving total
deregulation, it may also impose an unnecessary risk that poor initial market
performance will provoke a return to rate base regulation. An alternative
approach that would prolong the transition period te deregulation but reduce
the risk associated with that policy would be the gradual removal of rate base
regulation and other controls from the various markets served by the dominant
firm. Rate base regulation would be removed fran markets as actual and
potential competition develops. Other regulatory controls would be maintained

for a longer period of time to deter anticompetitive activities of the

_

23/This conclusion was reached in the recent Second Report in FCC Docket
20003. The issuance of this report terminated this inquiry that considered
the economic impact of new competition in terminal equipment and special ized
common carrier markets on the established common carriers.

24/This view is reflected, for example, in Alfred E. Kahn, “Applications
of Economics to an Imperfect World," American Economic Review Papers and
Proceedings 69 (May 1979):1-13.



A. Closed-Entry Models of Single-Output Natural Monopoly

The pioneering paper of Averch and Johnson in 1962 established the beginnings of
the formal, analytical study of the rate base regulated natural monopoly firm, 2/ The
traditional view of natural monopoly based on economies of scale is implied. 3/ Given
this traditional view of natural monopoly, potential entrants into the markets served by
the regulated monopoly firm are barred by law. The rate base regulated monopoly firm
is assumed to be a constrained profit-m aximizer, producing a single, homogeneous output
(say, "telecom munications service"). While the firm is constrained from earning full
monopoly profits, its allowed rate of return is assumed to exceed its financtal cost of
capital. In terms cf their static model, Averch and Johnson show that rate base
regulation creates an incentive for the inefficient substitution of capital for labor that
consequently distorts the input choices of the regulated firm away from production at
minimum cost. Moreover, such regulation creates an incentive for the regulated firm to
expand into other regulated markets, even if costs exceed revenues in those markets. 4/

In addition to the input distortions induced by rate base regulation, Charles Needy

shows that regulation may encourage the regulated firm to produce at nor-optim al levels

ee

2/Harvey Averch and Leland Johnson, "Behavior of the Firm Under
Regulatory Constraint," American Economic Review 52 (December 1962) :1053-69.

(3/The traditional, single-output theory of natural monopoly is discussed
by Alfred E. Kahn, The Economics of Re ulation: Principles and Institutions,
ve 1 (New York: John Wiley & Sons, J, pp. li-i2. The more recent
literature, however, shows that economies of scale are neither necessary nor
sufficient, for natural monopoly, even in the single-output case. See William
J. Baumol, "On the Proper Cost Tests for Natural Monopoly in a Multiproduct
Industry," American Economic Review 67 (December 1977) 809-22.

4/See Averch and Johnson, "Behavior of the Firm Under Regulatory
Constraint," p. 1052.


-19-

The concept of a dominant fim is a useful, operational way to
characterize a real-world business firm that has the potential "market power”
to behave more like a monopolist than a perfect competitor .32/ The concept
may suggest not only the relative "fewness" of firms in a given market but
also more importantly the unequal size (market share) of the dominant firm
compared to its competitors. As an indicator of dominance, Scherer defines a

dominant firm as one controlling roughly 40% or more of the industry's

_

32/The concept of "market" or "monopoly power" is not consistently
defined in the general economics literature. Rather, the concept is most
often encountered in the literature on antitrust law. See, for example,
Ernest Gelihorn, Antitrust taw and Economics in a Nutshell (St. Paul, Minn.:
West Publishing Co., 1976), Chapter IV. In most real-world markets, market
power is a matter of degree, since individual firms possess some influence
over output price. Thus, even retailers in imperfectly competitive markets
have some market power, jee., such firms have some leeway in setting prices.
Such a firm will lose some but not all its customers if it raises its
prices. In such a market, such monopolistically-competitive firms might be
described as "“price-searchers ,” since they search for a price that is most
consistent with the firm's objective, OoGe, profi t-maximi zation. Contrary to
the assumption of perfect or costiess information in the model of perfect
competition, real-world firms possessing some market power must somet imes
experiment or search for the price that maximizes profit or some alternative
business goals. The exercise of this limited market power reflects the cost
of obtaining necessary market information. In general, the exercise of such
limited market power does not represent @ serious threat to consumer
welfare. The exercise of market power by a firm possessing "“market-specific
daninance" as discussed Tater in the text will be inimical to consumer wel fare
and connotes a broader social concern, viz, the ability of the firm to keep
prices high, earn supranormal profits, and still exclude competitors. See
Franklin M. Fisher, "Diagnosing Monopoly,” The uarterly Review of Economics
and Business. 19 (Summer 1979):7-33. From peu point of view, theTM. «+ «
correct analysis of entry or barriers to entry lies at the heart of an
assessment of monopoly power." See ibid., pe 23. The analysis of regulatory
policy for transitional telecommunications markets as developed in this paper
is broadly consistent with Fisher's view of monopoly power. Moreover, this
analysis emphasizes the importance of open entry policies as constraints on
the exercise of discretionary market conduct by firms dominant in a specific
market.


Federal Communications Commission
Office of Plans and Policy

1919 M Street, N.W. — -..

Washington, D.C. 20554

A Working Paper on:

Reforming Regulatory Policy

for:
Private.Line Telecommunications

\ Services:

Implications for Market
Performance

December 1980

—=—<—<—<<—————

By: Jerry B. Duvall
Michael D. Pelcovits


-42-

Second, the market demand for PLS is probably reasonably elastic, given
the availability of competitive alternatives to AT&T's offerings. As the
choice of substitute private line services broadens in the near-term future,
market demand may became increasingly elastic. Consequently, AT&T's market-
Specific dominance viewed from the demand side of the PLS market is not quite
as overwhelming as its presence in the current MTS market. Given these
structural differences, performance in the PLS market should more closely

approximate a workably competitive market.

V. THE PROBLEM OF INTER-SERVICE CROSS-SUBSIDIZATION

The previous discussion suggests that the existing and near term
structure of PLS and MTS/WATS markets are quite different. As long as rate
base regulation of the MIS/WATS market is maintained, the problem of inter-
Service cross-subsidization between MTS/WATS and PLS must be considered. Over
the past decade the FCC has been concerned with the incentives that rate base

regulation establishes for shifting costs from competitive-like services to a


-6-

regulated monopolist. Moreover, it is generally implicitly assumed that the
administration of rate base regulation by real-world regulatory agencies is
both costless and effective, although sometimes subject to "regulatory lag."
Teleconmunications, however, can no longer be characterized as a closed-entry
industry in many of its interstate markets. Regulatory ‘models that relax the
assumption of closed-entry would seem both more realistic for modelling the
telecommunications industry as well as more informative concerning possible
public policy options. The more recent literature on the rate base regulated

firm has in fact pursued the implications of an open-entry market environment.

B. Open-Entry Models of Multi-Output Natural Monopoly

Title II of the Communications het of 1934 implicitly assumes that
interstate telecommunications services will be provided by regulated monopoly
telephone and telegraph firms. Today, neither AT&T nor Western Union are
complete monopolists in the markets they supply. Instead, these former
monopoly firms now share their markets with competitors. Moreover, modern
telecommunications entities such as AT&T produce not just one generic service
but a variety of differentiated tel ecommunications offerings. Consequently,
the emergence of the modern telecommunications firm producing a variety of
services in competition with recent market entrants poses regulatory
vifficulties not envisioned forty years ago. The more recent literature on
the rate base regulated firm addresses both issues by assuming both that the
regulated ‘firm produces multiple outputs and may be subject to competition

from new firns.


inefficiency is not as clear-cut as in the [basic] A-d mode?."10/ AS a
further example, Wesley A. Magat's dynamic Averch-Johnson model of induced
innovation challenges V. Kerry Smith's conclusion that rate base regulation
will bias technological change toward capital-using innovations.11/ One
conclusion that can be drawn from these dynamic Averch-Johnson analyses is
that the extent of economic distortions induced by rate base regulation should
be investigated empirically.12/

In general, the literature that has followed the Jead of the original
Averch-Johnson contribution has focused on the static econonic efficiency
implications of rate of return regulation. This literature typically assumes

that non-regulated firms are prohibited from entering markets served by the

ee

10/Alvin K. Klevorick, "The Behavior of a Firm Subject to Stochastic
Regulatory Review", The Bell Journal of Economics and Management Science 4
(Spring 1973):78-

lMesley Ay Magat, "Regulation and the Rate and Direction of Induced
Technical Change," The Bell Journal of Economics 7 (Autumn 1976 ):478-96.

12/Some empirical . evidence concerning economic distortions that may be
induced by RBR is beginning to accumulate. Evidence consistent with the
static “Averch-Johnson effect" in the electric power industry is found by
Robert M. Spann, "Rate of Return Regulation and Efficiency in Production: An
Empirical Test of the Averch-Johnson Thesis," The Bell Journal of Economics
and Management Science 5 (Spring 1974):38-52; Leon Courville, "Regulation and
Efficiency in the ectric Utility Industry," The Bell Journal of Economics
and Management Science 5 (Spring 1974):53-74; He Craig Petersen, "An Empirica
est of Regulatory Tffects,” The Bell Journal of Economics and Management
Science 6 (Spring 1975):111-26; and Paul M. Hayashi and John M.trapani, "Rate
of Return Regulation and the Regulated Firm's Choice of Capital-Labor Ratio:
Further Empirical Evidence on the ‘Averch-Johnson Model ," Southern Economic
Journal 42 (January 1976 ):384-98. Empirical evidence concerning the effect of
rate base regulation on “the direction of technological change in the Bell
System is provided by Jerry B. Duvall, “The Induced Innovation Hypothesis and
Biased Technological Change in the Domestic Tel ecommunications Industry: A
Microecononetric Analysis," Dissertation Abstracts International 40 (August
1979):964-A.



-55-

Most importantly, the private line carriers that AT&T might attack by
predatory pricing could resell AT&T's services in order to minimize their own
losses. Thus, a competitor could expand its customer base and penetrate other
markets including MTS, while under predatory attack without incurring any
additional cost of facilities. In the event that AT&T raised prices, its
competitors could lower their output by reselling less than before. ATAT
would then absorb the entire loss due to its inability to Tease the excess
facilities that were expanded to meet demand stimulated by the initial price
cut. A resale policy, therefore, shifts almost the entire cost of predatory
pricing onto the dominant firm and destroys its effectiveness as an entry
forestalling strategy.

In the event the regulation of the terms of sale in the PLS market are
not effective at restraining predatory conduct, more stringent controls could
be applied short of reimposing rate base regulation. Most of the problems
inherent in relying on cost data to restrict dominant firm behavior can be

avoided by focusing directly on its pricing strategy.87/ The setting of price

ee

87/An alternative rule discussed by Williamson could prohibit the firm
from responding to a rival's entry by ‘increasing output faster than market
demand. Therefore, even if it cuts prices, AT&T would be unable to satisfy
demand by itself and would leave shortages to be filled by competitors at a
higher price. Although this approach could easily be implemented through the
Section 214 process, it has several drawbacks as identified by Baumol. First,
it requires a projection of future demand which is particularly difficult in a
rapidly expanding industry subject to technical innovations. Secondly, it
prevents competitive price reductions by the dominant firm in response to
entry. Nevertheless, the Williamson Rule demonstrates a creative and perhaps
informal use of Section 214 authority to oversee AT&T's expansion plans in
markets where it faces scompetitive entry. Williamson argues that if large
economies exist, a rule of this nature would be superior to a cost test, since
a dominant firm would evade a cost test by building the excess capacity that
would allow it to respond to entry by increasing output, while still
maintaining price above cost.


-38-

common carriers as well as AT&T.62/

Furthermore, the conduct of buying and selling in the PLS market will
differ fran the MTS/WATS market. Since PLS is a business service market,
purchasers of the service are frequently professional buyers who are well
informed of competitive alternatives and their prices. As economists
increasingly began to emphasize in the 1970's, the functioning of a market
depends to a considerable extent on the quantity and quality of information
available to buyers.63/ But the production of information is costly.
Therefore, consumers will "search" for price and product information so long
as the potential benefits from continued search (e.g., lower prices) exceed
the costs.64/

Various models of market behavior that include information cost have

appeared in the recent literature.65/ A recent model advanced by Schwartz and

62/A brief yet somewhat dated discussion of the variety of services
provided by the SCC's and their -similarities and differences compared to
AT&T's private line services is provided by Robert F. Stone, Mark A.
Schankerman, Chester G. Fenton, Selective Competition in the Telephone
Industry (Cambridge, Mass., T+€, 1976), Chapter 6.

63/The classic reference is George Stigler, "The Economics of
Information," Journal of Political Economy 69 (June 1961):213-35.

64/A major criticism of the textbook models of perfect competition is the
implicit assumption of zero search costs. Thus, it is assumed that consumers
know without searching the competitive price corresponding to minimun average
cost of the firm. More realistically, of course, observed retail prices of
homogeneous products tend to follow a frequency distribution with monopoly and
competitive prices at each tail of the distribution. The persistence of such
a distribution reflects at least in part the cost of information necessary to
collapse the distribution at the competitive price.

§5/For an overview of some of the recent issues in the economics of
information, see Joseph E. Stiglitz, “Symposium on Economics of Information:
Introduction," Review of Economic Studies 44 (October 1977):389-391,



-26-

service, digital or analog, or other defining attributes of the service.
While sometimes difficult in practice, real-world markets can be delineated in
terms of Lancasterian characteristics. Markets viewed in this way are
appropriate for assessing the extent of market-specific dominance.

The notion of market-specific dominance as discussed so far is
unnecessarily static in nature, i.e., the market is examined in terms of
existing substitute commodities with similar characteristics. A forward-
looking perspective, however, is more useful for evaluating both the present
as. well as future performance of the market. In “assessing market-speci fic
dominance for a particular firm as a factor explaining or influencing market
perfonnance, some recognition of potential entrants is essential. Such a
forwarding-looking emphasis is not new; J. Be Clark, for example, emphasized
the importance of "potential competition” as a factor influencing the conduct
of dominant firms. More recently, John Panzar in developing his notion of
"structurally contestable” markets has ndéted that

Efficient market performance is expected to result From
e large number o po ential entrants ani @ easy entry

and exit dictated by the technology, in other words,
because the market is easily contested.45/

45/John C. Panzar, "Regulation, Deregulation, and Economic Efficiency:
The yor of the CAB," Anerican Economic Review Papers and Proceedings 70 (May
1930):311.



-43-

monopoly service by a multi-output, regulated firm such as AT&T.71/ In Docket
18128, the FCC prescribed a fully-distributed costing methodology (FDC) for
detecting inter-service cross-subsidization.72/ The allocation of cost into
17 service categories was mandated to protect the rate payer from unlawful

service cross-subsidization. Implementing this decision as originally

eo

71/More specifically, the notion of cost shifting has focused on the
incentives for a rate base regulated firm to classify costs as
“unattributable” rather than "directly attributable." Unattributable costs
cannot be directly linked on a "cost causational" basis to specific services
and correspond Joosely to the economist's concepts of joint and common
costs. A rate base regulated finn facing competitive entry in selected
markets may have an incentive to classify costs as unattributable (and
possibly engineer plant to be joint cost in nature) so that the incremental ,
attributable costs of producing the competitive services appear low.
Consequently, using an incremental cost standard, the rate base regulated firm
can justify "low" tariffs for services facing competitive entry. This
possible manipulation of the regulatory cost standard among other difficulties
Jed the FCC to reject AT&T's notion of "long run incremental cost" (LRIC) as
the basis for legal costs in Docket 18128. See 61 FCC 2d 615 (1976). For
further discussion, see Roger Ge Noll and Lewis A. Rivlin, "Regul ating Prices
in Competitive Markets,” Yale Law Journal 82 (June 1973): 1426-1434. Of
course, other regulatory cost Standards, including fully distributed cost
(FDC) methodologies considered in Docket 18128, are also subject to
mafipulation and may provide incentives for the regulated firm to classify
costs as unattributable.

72 /Ouring the deliberations in the Docket 18128 proceeding, AT&T opposed
the usage of FDC as a test for inter-service cross-subs idi zation. AT&T
proposed instead the "burden test" that estimates the net revenue and cost
reductions occasioned by eliminating a particular service offered by a multi-
output firm. The FCC, however, adopted FDC as its cost standard for ATaT and
therefore defined inter-service cross-subsidy in terms of this methodology.
See 61 FCC .2d 615 (1976). For a brief discussion of various concepts of
cross-subsidization, see Edward E. Zajac, Fairness or Efficiency (Cambridge,
Mass.: Ballinger Publishing Co-, 1978), Chapter 3. uci scussion of the
Docket 18128 proceeding -and its historical context is provided by Walter G.
Bolter, "The Fcc's Selection of a ‘Proper’ Costing Standard after Fifteen
Years--What Can We Learn From Docket 18128?" in Assessing New Concepts in
Public Utilities, ed. Harry M. Trebing (East Lansing, che: Michigan State
University, 978), pp. 333-372.


-25-

measurable characteristices in fixed Proportions.44/ For example, the demand
for a specific private line service could be defined in terms of several

technical and economic Characteristics such as switched or non-switched

44/The traditional approach for defining a market as followed in the
industrial organization literature emphasizes the extent of product
substitution among similar commodities as well as the extent of possible
supply-side input substitution in production. In many studies demand side
product substitution is emphasized and, in more technical terms, is conceived
and measured in terms of “goods space.” Consequently, market boundaries are
often drawn arbitrarily in: terms of a qualitative assessment of the probable
degree of substitution among various similar commodities. Sometimes an
attempt is made to quantify the extent of substitutability by estimating a
coefficient of cross elasticity of demand. In either event, traditione?
qualitative and quantitative approaches raise numerous conceptual and
measurement problems that often lead to excessively broad or narrow market
definitions for commodities comprising an industry. These difficult problems
are clearly discussed by Scherer, Industrial Market Structure and Economic
Performance, pp. 59-64. In addition, the history of anti-trust Titigation
Suggests that courts sometimes appear to delineate market boundaries in such a
way to justify a desired outcome. See, for example, the discussion in
Scherer, Chapter 20.

A major advantage of Lancaster's reformulation of demand theory is the
definition of a good or service in terms of “characteristics space” rather
than goods space of traditional theory. In technical terms, the fundamental
relationship between a vector“of characteristics, z, and a vector of goods, x,
is given by z = Bx, where B is a semipositive matrix describing the
“consunption technology." If r and n indicate the number of distinct
characteristics and goods respectively, then B is order r x n where,
generally, r <n, although not necessarily. If the consumption technol ogy
matrix B is square and diagonal, then the traditional theory of the consumer
is just a special case of Lancaster's model such that a single, unique
Characteristic is associated with each good. Having defined a good in terms
of characteristics, a Lancasterian definition of a commodity "group" or
"industry" follows naturally: an industry is defined in terms of the 8
matrix. If the B matrix is block triangular such that matrices Bi, B., and
B3, form the principal diagonal with null matrices elsewhere, an industfy can
be defined in terms of the block of coefficients that form B,, B,, and Ba.
The block of coefficients represented by, say, By define a produc group or
industry that share specific characteristics in common, i.e., commodity
attributes not shared by any other product. While this approach to market
definition appears abstract, it provides a conceptual foundation for
developing relatively clear-cut market boundaries in terms of observable
product attributes. Lancaster's approach offers a powerful alternative to the
traditional market boundary methodology. For further discussion, see
Lancaster, Consumer Demand, Chapter 8. A brief but clear discussion is also
provided by Dona’ A. Hay and Derek J. Morris, Industrial Economics: Theory
and Evidence (Oxford: Oxford University Press, 1979), pp. 88-92.



Since the proposed deregulation of AT&T's private line markets raises the
possibility of dominant firm, anti-com petitive conduct such as predatory pricing, Section
III examines the economics of the multt-output dominant firm. The concept of market-
Specific dominance is developed and then applied in the subsequent analysis. Section IV
characterizes in economic terms the current PLS and Jong distance interstate
telecom munications message (MTS) markets. Following this discussion of the MTS and
PLS markets, Section V briefly considers the regulatory problem of inter-service cross-
subsidization. Section VI discusses the pricing behavior of a dominant firm in a
deregulated market environment and considers policies designed to forestall predatory

pricing. Finally, Section-VII sum marizes the argument of the paper. 1/

I. RATE BASE REGULATION AND ECONOMIC EFFICIENCY

In recent years rate base regulation of public utilities has been extensively re-
examined by academic economists. This growing literature has identified various
potential distortions in input usage, output levels, pricing, and other dimensions of
regulated firm conduct resulting from the application of rate base regulation.
Contributions to this literature can be roughly classified into two groups that reflect the
order of historical development, viz., 1) closed-entry models of single-output natural
monopoly and 2) open-entry models of multi-output natural monopoly. While this
classification may not be appropriate for characterizing all contributions to the
literature, it reflects nevertheless the different focus of the more recent literature as

com pared to the earlier contributions.

1/The legal implications of the proposal are not considered in this
paper. The omission of legal analysis does not imply such considerations are
unimportant or trivial. Rather, the economic analysis is presented without
the complexity of legal arguments so that the economic logic can be sharply
focused.


~16-

return constraint. If performance appears satisfactory, remaining regulatory

contraints could be relaxed.29/

29/The proposed regulatory reform discussed in this paper is not entirely
new. In 1968, Professor Harold Wein of Michigan State University proposed, as
a consultant to the FCC in Docket 16258, that

« « » the rate level for MTT (now MTS) services
as a whole be determined on the basis of the
average cost of these services, plus a fair rate
of return. Since much plant of these services is
used in common with other services, its costs
must be obtained by allocation methods. These
methods can be improved through more careful
sampling procedures and more precise definition
of usage...

Concerning AT&T’s competitive, interstate PLS services, Wein recommended that

+ + « Bell management be given the option of
pricing the other (i.e., competitive) services at
- such levels as they deen appropriate to meet
competitive conditions. If the rates chosen for
these services, together with the fair rate of
return on MIT services, do not yield a fair rate
of return on total interstate plant, the
deficiency should be borne by the AT&T
stockholders. If the rates chosen by AT&T
management for those other competitive services,
together with the fair rate of return on the MTT
services yield a return that exceeds the fair
rate of return for the total interstate plant,
the benefit will accrue to the company's
‘ stockholders.

See "Testimony of Harold H. Wein," Docket 16258, FCC Staff Exhibit 50, July
22, 1968, p. 169. While Wein's policy recommendations overlap in part with
those developed in this paper, the theoretical perspective developed here
differs substantially from Wein's testimony.


~53-

accept a reduced market share, rather than face a regulatory proceeding
instituted by its competitors. Considering the ambiguous nature of cost data,
too high a cost floor could easily be supported by an improper interpretation
of that data.

Regulation of the terms on which PLS is offered, however, should be
retained to discourage predatory pricing in selected markets by AT&T. The
FCC's regulatory powers can be directed in two ways at altering the potential
payoff to this predatory strategy. First, AT&T's freedom to control its own
losses from price cutting can be eliminated. The major tools essential for
such a policy, viz., tariff filing and simplification, resale, and non-
discriminatory access, are already at hand. Moreover, they can be extended ‘as
necessary to prevent AT&T fron controlling its own losses from predatory
pricing or containing the spillover of predation to other markets. Secondly,
these same regulatory policies will help AT&T's competitors minimize their
losses from a predatory foray by reselling AT&T's services.

More specifically, any private line offering under current regulations
must be public and available to all customers on a nondiscriminatory basis.
The FCC is also considering a restructuring of AT&T's PLS tariffs from their
existing 26 interstate categories to a few basic services. 83/ Tariffs for
PLS should then be unbundled with a price for each service clearly

established. This simplication will allow customers to assemble optimal

83/See Notice of Inquiry and Proposed Rulemaking in the Matter of AT&T
Private Line Rate Structure and Volume Discount Practices, Docket 79-246.



~33-

TABLE 4

TOTAL SPECIALIZED COMMON CARRIER
REVENUES AS-A PERCENTAGE OF TOTAL BELL SYSTEM
INTERSTATE AND INTRASTATE PLS REVENUES,

1975-1979
Percentage of Percentage of
Year Bell System Interstate Bell System Combined
PLS Revenues Only Interstate and Intrastate PLS Revenues
1975 3.13 2.38
1976 7.87 5.87
1977 10.95 7.99
1978 12.78 9.23
1979 17.69 12.75

SOURCE: Monthly Report No. 4 and FCC Form P (Annual Report of Miscellaneous
Common Carriers).


-34-

vis a vis the Bell System's PLS market .53/

Tables 1 through 4 provide a quantitative overview of the MTS/WATS and
PLS markets. Such data do not emphasize, however, certain underlying
structural differences between the MIS/WATS and PLS markets. These structural
differences, quite apart from the substantial differences in revenues for the
two markets, establish the basis for differential regulatory treatment of the
PLS market as compared to the market for MTS/WATS. On the supply side, the
technology and cost functions for MTS/WATS and PLS differ, although some plant
is jointly used. In general, MTS/WATS are switched analog services satisfying
both residential and business customer needs for “anybody-to- anybody"
service. In contrast, private line services consist of various switched and
dedicated services, both analog and digital, satisfying business needs for
point-to-point service.54/

On the demand side, the type of customer and the individual demand
functions for MTS/WATS and PLS are substantially different. More

specifically, the demand for interstate MTS represents a mixture of residence

—_——

53/Table 3 should not be interpreted as necessarily suggesting
significant growth in the SCC's market share of the PLS market since Form P
data also include revenues for MIS-like services,

54/To simplify the ensuing discussion, the various Bel] System services
listed in Table 2 and the competing services offered by the SCC's will be
treated as a single, generic market. Whether each individual private line
service should be viewed as a PLS sub-market with its own cost function and
Lancasterian characteristics, is not entirely clear at this time. See Notice
of Inquiry and Proposed Rulemaking in the Matter of AT&T Private Line Rate
Structure and Votume Discount Pract ce, Docket 79-246, FCC 2d 226 (1979).
le argument of this paper is not affected, however, by treating all private
line services as a generic whole.


~49-

future profits.78/ In the PLS market, due to the absence of significant cost
advantages and the rapid pace of entry, even the best designed pricing
strategy will not yield AT&T excess profit for very long, and rules
restricting its pricing freedom may have little value.

The potential welfare gains fron deregulation, moreover, appear to
outweigh the efficacy of rate base regulation for attenuating a limit pricing
strategy for PLS by AT&T. A major advantage of deregulating the PLS market is
that prices could adjust quickly to reflect present and near-term opportunity
costs rather than the embedded or historical accounting costs, although prices
would still be distorted to some extent by the application of the Docket 79-
245 cost allocation process. This pricing flexibility would promote economic
efficiency by 1) allowing PLS prices ‘to reflect quickly the benefits of new,
low-cost technologies; 2) permitting excess demand to be rationed through
price changes that may also signal the need for new capacity; and 3)
accommodating any PLS peak-load or time-of-day usage patterns. Such pricing
flexibility provides a major stimulus to improved market performance by
sharply reducing the incentives for distorted resource allocation that rate of
return regulation implies.

Given the market power of AT&T in a deregulated PLS market, would not
AT&T use its new pricing flexibility to price its private line services anti-
competitively? In particular, would not AT&T attempt to force its PLS fringe

competitors out of business by predatory pricing practices? While such fears

78/The classic exposition of the economic theory describing the dominant
firm's optimal pricing strategy is by Darius W. Gaskins, Jr., “Dynamic Limit
Pricing: Optimal Pricing Under Threat of Entry," Journal of Economic Theory 3
(September 1971) :306-22.



-22-

imprecise.38/ Furthermore, there is sometimes a tendency to focus on market
structure as a policy objective itself apart from the implications for good
market performance. Stigler, however, has observed that

In economic life competition is not a goal: it is a
means of organizing economic activity to achieve a
goal. The economic role of competition is to discipline
the various participants in economic life to provide
their goods and services skilfully and cheaply.39/

The discussion of this paper reflects a fundamental concern for good market

performance. Market structure is considered satisfactory or socially-

acceptable if the market performs well.

38/Furthermore, the relationship may be subject to important
exceptions. For example, a “natural monopoly" may under very special
conditions achieve better market performance than a more competitive
industry. As discussed previously, the theoretical requirements necessary for
this concTusion, however, are very restrictive and may not be satisfied in
real-world markets. Also, the recent literature on information cost and
market transactions significantly qualifies the standard conclusions
concerning the optimality of pure campetition. The role of information cost
and consumer search behavior on market performance is discussed later in the
paper.

39/Stigier, The Organization of Industry, p. 5.



-52-

price floor.82/ The dominant fim may under certain circumstances price below
average cost (but above marginal cost) as a Justifiable reaction to excess
Capacity in the industry. On the other hand, a marginal cost standard is
unlikely to place a serious constraint on predatory behavior because fixed
costs are such a large share of total costs. In brief, utilizing cost data to
set a floor below which prices would be considered predatory requires the FCC
to apply a detailed cost standard as a regulatory tool, an approach that the
FCC has found extremely difficult to devel op. and apply to date.

Relying on cost data to prevent predatory pricing may also have
detrimental effects. Inefficient competitive firms could seek protection
under a price umbrella set by the dominant firm above its cost of

production. The dominant firm may readily adopt and maintain a high price and

Sa

82/The establishment of a test for predatory pricing has been the focus
of several recent articles. Areeda ‘and Turner Opened the controversy by
advocating a marginal cost standard which would be applied using average
variable cost as a suitable measurable proxy. See Phillip Areeda and Donald
F. Turner, "Predatory Pricing and Related Practices Under Section 2 of the
Sherman Act", Harvard Law Review 88 (February 1975) :697-733, Scherer,
Williamson, and” Joskow and K evorick are all unwilling to rule out pricing
below average cost (but above marginal cost) as predatory. In order to apply
an average cost standard, however, they have had to develop a further
screening to distinguish competitive fran predatory. behavior. Williamson
would focus on the output response of the firm to competitive entry, See
Oliver E, Williamson, “Predatory Pricing: A Strategic and Wel fare Analysis",
Yale Law Journal 87 (December 1977):284-340. Joskow and Klevorick would only
apply a cost’ standard to an industry that is structurally susceptible to

defense that excess capacity in the industry justified pricing below average
cost. See Paul L. Joskow and Alvin K. Klevorick, "A Framework for Analyzing
Predatory Pricing Policy,” Yale Law Journal 89 (December 1979):213-270. It
would appear that the FCC wou ve a hard time implementing any comp] ex
Standard without utilizing the same market and cost data that the FCC has
attempted to use for ratemaking purposes but with little apparent success to
date. See also F. M. Scherer, "Predatory Pricing and the Sherman Act: A
Comment", Harvard Law Review 89 (March 1976):868-903.




-41-

date had a major impact on the performance of the MTS/WATS market.69/
Moreover, the market demand for MTS is probably less elastic in general than
for PLS, given the present lack of alternatives to MTS for long distance
telecommunications for many users. This situation will probably change,
however, as competition develops in the MTS/WATS market. But, for the
present, AT&T remains dominant in the MIS/WATS market viewed from either the
demand or the supply side of the market.

In terms of the PLS market, AT&T's market-specific dominance is less
pronounced. First, AT&T faces substantial competition on the supply side of
the PLS market. While existing fringe competitors such as MCI and Southern
Pacific may influence AT&T's pricing conduct to some extent, the major near-
term competitive threat to important segments of AT&T's PLS market is the
beginning of entry by new communication firms such as SBS and the potential
entry by others such as the Xerox Corporation's XTEN "digital termination
service."70/ So long as the threat of entry of such large corporate entities
is credible, such potential competitors to AT&T provide an important
constraint on the potential ‘abuse of dominant-firm market power by AT&T. The
possibility of these “build around" communications entities competing with
AT&T in the PLS market provides a strong incentive for competitive-like

conduct by AT&T.

ss
69/See "Business Consumers Step Up Use of Phone Service From Bell
Rivals,” Wall Street_Journal, 9 July 1980, p. 26.

70/See Notice of Proposed Rulemaking and Inquiry in Docket 79-188,
released August 29, 1979.



-39-

Wilde emphasizes that equilibrium market price depends on both the number of
"shoppers" in the market and the adoption of a “mixed search strategy."66/ In
terms of their model, Schwartz and Wilde observe that

+ «+ + Because some consumers always comparison shop,
firms that cut prices could be rewarded and firms that
raise prices could be punished. The extent to which the
prospect of reward or punishment influences firm behavior
depends upon the ratio of comparison shoppers to the
total number of shoppers in the market. If that ratio is
sufficiently great, the market will generate a
competitive equil ibrium.67/

The existence of well-informed, professional buyers or "shoppers" for PLS
should have a considerable impact on the performance of this market, forcing
the real-world frequency distribution of market prices toward the competitive
price. Thus, given both the number of competing PLS carriers and the

resources allocated by business customers to product "search," prices for PLS

66/Alan Schwartz and Louis L. Wilde, "Intervening in Markets on the Basis
of Imperfect Information: A Legal and Economic Analysis," University of
Pennsylvania Law Review 127 (January 1979):630-682. A more technical paper
that eve ops the underlying mathematical analysis is provided by Louis L.
Wilde and Alan Schwartz, ."Equilibrium Comparison Shopping,” Review of Economic
Studies 46 (July 1979):543-553.

67/Schwartz and Wilde, "Interviewing in Markets on the Basis of Imperfect
Information: A Legal and Economic Analysis," p. 650.


-9-

difficult.17/ In brief, the sustainability Yiterature is still evolving and
as yet is not sufficiently developed to address all complexities of regulatory
policymaking for the telecommunications industry .18/

While significantly strengthening the theoretical foundation of regulated
natural monopoly, the recent literature ignores important dimensions of the
real-world practice of rate base regulation and the actual functioning of
regulatory agencies. The interaction between the regulatory agency and the
regulated industry may lead to the “capture” of the regulatory commission by
the industry; delay the pace of economic development and growth of the

regulated industry; retard the adoption of new technologies; and encourage

_

17/Sufficient conditions for subadditivity are established in Baumol, "On
the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry." An
-empirical study of cost function subadditivity is provided by W. J. Baumol and
Y,. Ms Braunstein, "Empirical Study of Scale Economies and Product
Complementarity: The . Case of Journal Publication," Journal of Political
Economy 85 (October 1977): 1037-48. A methodology for guiding econometric
work on multi-output cost function estimation is provided my W. J. Baumol,
Dietrich Fischer, and M I. Nadiri, "Forms for Empirical Cost Functions to
Evaluate Efficiency of Industry Structure,” Center for the Study of Business
Regulation Paper No. 30, Duke University, 1978.

18/Recently, the focus of the sustainability literature has shifted
toward the formulation of a general industrial organization paradign stressing
the relationship of technology-determined industry cost functions and the
resulting’ market structure. The natural monopoly firm, therefore, is simply a
"special case" in a more general industrial organization model. See We de
Baumol and D. Fischer, "Cost Minimizing Number of Firms and Determination of
Industry Structure,” uarterly Journal of Economics 92 (August 1978):439-67
and Robert D. Willig, Multi product Technology and Market Structure," American
Economic Review Papers and Proceedings 69 (May 1979):346-351.



-51-

incurred by the firm in using predatory pricing in one market may generate
greater deterence benefits in other markets" and cause competitors to be
reluctant to enter any of the firm's markets .80/

Attempting to identify and forestall this pricing strategy by using cost
data to establish a price floor is a difficult regulatory task. The cost data
must be obtained for the specific market thought to be under attack by a
predator. Clearly, accurate data are necessary for such review purposes. But
a major difficulty with obtaining relevant cost data is choosing an
appropriate cost standard.81/ Any cost standard is subject to dispute. For

example, there are drawbacks in using either average or marginal cost as the

80/Richard A. Posner, Antitrust Law: An Economic Perspective,
(Chicago: University of Chicago Press, 1976), p. 186.

81/The FCC in its Docket 18128 decision selected fully distributed cost
Method 7 as its "legal cost" standard for promoting the regulatory goal of
carrier “accountability.” As Braeutigam shows in the article cited in
footnote 74, a fully distributed cost standard may not promote economic
efficiency. Consequently, to the extent that an efficient allocation of
resources is a desirable regulatory and social goal, then some cost concept
other than FDC may be preferable for developing a cost test for predatory
pricing.



-57-

VII. CONCLUDING OBSERVATIONS

The deregulatory proposal of this Paper is a modest step toward ‘improved
market performance in the private line market. Without a rate-of-return
constraint on its PLS earnings, AT&T is provided an important incentive for
greater innovation and improved customer service. If it is successful in its
efforts, AT&T will realize earnings unconstrained by rate of return
regulation. Both AT&T's customers as well as shareholders should benefit from
this regulatory reform Moreover, an analysis of AT&T's market-specific
dominance shows that both the present availability of competing private line
services and the near term entry of new communications entities provide
constraints on potential anti-competitive conduct by AT&T.

The FCC already has in place most of the necessary policies for
encouraging workable competition in the PLS market. Expanded resale policies
and the assurance of nondiscriminatory access to dominant carrier facilities
will provide the essential regulatory input for achieving better performance
in the PLS market. The danger of predatory conduct by AT&T toward its fringe
Competitors is, perhaps, real, although the Jong tem threat to such
competitors can be exaggerated. The adoption of a simplified cost allocation
manual would provide a workable regulatory tool that cquld detect gross abuse
of market power by AT&T. By specifying unambiguous, auditable, although
arbitrary procedures for separating both the directly assignable expenses and
plant investment as well as the Jointly-used facility costs of PLS from
MTS/WATS, the FCC can restrict AT&T's ability to shift costs between PLS and
MTS/WATS for purposes of inter-service Cross-subsidization. Nothing further

is gained while economic efficiency is lost by also imposing a rate-of-return


-11-

regulation of» public utilities.20/,21/ In the teleconmunications industry,
the entry of new firms during the 1970's in the markets for terminal equipment.

and specialized common carrier services expanded significantly the range of

_

20/See, for example, Nina W. Cornell, Daniel Kelley, and Peter Re
Greenhalgh, "Social Objectives and” Competition in Common Carrier
Communications: Incompatible or Inseparable?", FCC Office of Plans and Policy
Working Paper #1, April, 1980..

21/In recent years, deregulation of certain regulated industries has
gainéd increasing support among economists as a policy option for improving
market performance. By examining the economic impact c* rules on market
structure and firm conduct, economists are finding that some rules simply
protect existing firms from competition while providing little or no benefit
to consumers. Even worse, some rules impose substantial costs on both the
regulated industry and consumers with no apparent benefit to anyone. The
removal or modification of such costly, outmoded regulations clearly provides
unambiguous gains in producer and consumer welfare. It must be emphasized,
however, that simply removing rules that constrain firm behavior or restrict
entry into an industry need not automatically lead to the emergence of a
competitive industry, even after a substantial adjustment period. While
deregulatory policy may not lead to a more competitive market structure and
may prove unsatisfactory ‘from an anti-trust perspective, market performance
given the existing market structure can sometimes be improved by simply
lifting restrictions that distort firm conduct. The regulatory reform
proposed in this paper places emphasis on the importance of this latter view
of deregutation.


REFORMING REGULATORY POLICY FOR PRIVATE LINE
TELECOMMUN ICAT IONS SERVICES: IMPLICATIONS FOR

MARKET PERFORMANCE

Jerry B. Duvall and Michael D. Pelcovits */

December 1980

_

*/Senior: Staff Economists, office of Plans and Policy, Federal
Communications Commission. The views expressed are those of the authors and
do not necessarily represent those of the Commission or its staff. The
authors wish to thank Nina Ww. Cornell, Douglas We Webbink, Ae Daniel Kelley,
James T. Brown, Boyd Le Nelson, Walter G. Bolter and Robert Preece for hel pful
comments and suggestions on various drafts of the paper. Special thanks are
due Timothy K. Stevens of the FCC's Common Carrier Bureau for valuable
insights that have been incorporated within the paper. The authors accept
full responsibility, however, for any errors that remain.


-32-

TABLE 3
TOTAL SPECIALIZED COMMON CARRIER
REVENUES, 1975~1979

($000)
Specialized Year
Communication . .

Service 1975 1976 1977 1978 1979
Dedicated Voice Grade nea. Nede 69,852 81,993 98 431
Shared/Switched Voice Grade Neds Nea. 36,108 57,324 137,938
Dedicated Data - - -
Shared/ Switched Data Neds - Nede Tl 1,654 557
Other Operating Revenue Nede Nea 12,118 15,443 10,043

Total . 29,978 80,769 118,199 156,414 246, 968

SOURCE: FCC Form P (Annual Report of Miscellaneous Common Carriers).

Neas: not available


-20-

output.33/ In one textbook classification, the dominant firm falls between a
pure monopoly and a "tight oligopoly" where the latter functions as if it were
a "shared monopoly."34/

While the notion of a dominant firm as an empirical concept is not
entirely clear-cut, most industrial organization textbooks hypothesize a
causal relationship between a firm's dominance in the market and market
performance.35/ Firm dominance as an attribute of market structure usually
implies that the firm has sufficient market power to influence product price

(among other dimensions of seller conduct) such that market performance is

33/F. M. Scherer, Industrial Market Structure and Economic Performance,
2d ed. (Chicago: Rand McNally, >» Pe 232. Alternatively, Williamson
requires that a dominant firm exceed a 60% market share and that barriers to
entry to the market are “great". See Oliver £. Williamson, Markets and
Hierarchies: Analysis and Antitrust“‘Implications (New York: The Free Press,
1975), pe 209.

34/William G. Shepherd; The Economics of Industrial Organization
(Englewood Cliffs, Neds: Prentice-Hall, 1979), pp. 62-63.

35/Market “performance" as used in this paper follows the standard
"structure-conduct-performance" paradign of the industrial organization
literature. The various dimensions of market performance usually include
static and dynamic economic efficiency, consideration of equity, and certain
macroeconomic objectives. For a complete discussion of this model for
industrial organization studies, see F. M. Scherer, Industrial Market
Structure and Economic Performance, 2d ed. (Chicago: Rand McNaTTy, 1980),
japter 1. recent criticism of this standard paradign fron an "Austrian"
perspective is provided by W. Duncan Reekie, Industry, Prices and Markets (New
York: John Wiley & Sons, 1979). The views expressed in this paper are
sympathetic with Reekie's criticisms of the application of static
neoclassical economics. More specifically, this paper emphasizes the
importance of dynamic efficiency in assessing market performance and the
disequilibrium characteristics of most real-world markets.



The FCC Office of Plans and Policy Working Paper Series
presents staff research at various states of development. These
papers are intended to stimulate discussion and critical comment. both
within the FCC as well as outside the agency on issues in
contemporary telecommunications policy. Titles in the OPP Workin
Paper Series will include preliminary “think pieces," interim project
Progress reports, as well. as completed research scheduled for .
publication on broadcasting, common carrier, cable, and other aspects
of teleconmunications regulation. The analyses and conclusions
presented in the OPP Working Paper Series are those of the authors
and do not necessarily reflect the views of other members of the
Office of Plans and Policy, other Commission staff, or the Commission
itself. Upon request, single copies of working papers will be
provided as well as an updated list of current and proposed working
paper titles. Given the preliminary character and tentative-views
contained in some titles in this series, it may be advisable to check ~
with authors before quoting or referencing working paper titles in
publications. Periodic public notices will announce additions to the
Series.

Copies of the OPP Working Paper Series may be obtained from
the Office of Public Affairs, Federal Communications Commission, Room
207, 1919 M Street, N.wW., Washington, D.C. 20554, (202) 254-7674.
Copies are also available for a fee from the Downtown Copy Center,

. 1114 21st Street, N.W., Washington, D.C. 20037, (202) 452-1422.

For information concerning the content of the OPP Workin
Paper Series, contact the Office of Plans and Policy, Federal
Communications Commission, Room 838, 1919 M Street, N.W., Washington,
D.C. 20554, (202) 653-5940. The Office of Plans and Policy will
also have a limited number of copies available for distribution.



-44-

planned, however, has Proved to be a formidable task.73/

Major simplifications in the costing methodology prescribed in Docket
18128 including the use of telephone industry "separations" data are currently
Proposed by the FCC's Common Carrier Bureau in Docket 79-245, These
simplified guidelines should enable the FCC to monitor AT&T's cost allocation
in broad terms and across only three service categories, viz., MTS, WATS, and

PLS, rather than in fine detail as originally contemplated in the Docket 18128

73/At present, ongoing Docket 79-245 is considering the prescription of a
cost allocation manual that will finally official] establish the procedures
for the application of the cost allocation guidel thee established in Docket
18128 in 1976,


-28-

IV. THE MARKETS FOR MTS/WATS AND PLS

At present there are significant structural differences between the
MTS/WATS and PLS markets that may imply significant differences in market
performance if the rate-of-return constraint is rel axed.47/ First, the size
of the current PLS market is substantially smaller in sales volume as compared
to the MIS/WATS market.48/ Table 1 presents data on total annual Bell System
interstate MTS, WATS, and toll PLS revenues for the years 1972-1979 as
reported on year-end Report No. 4 (Bell System Operating Revenues) filed
monthly with the FCC.49/ As the data for 1979 suggest, the combined revenues
for MIS and WATS are nearly ten times that of PLS. Second, the PLS market, in
sharp contrast to the MTS/WATS market, consists of a variety of individual PLS
services, with each service as presently tariffed appearing to have somewhat
different technical characteristics. Table 2 shows the total annual
interstate revenues for each Bell System private line service as reported on
Monthly Report No. 4 for the years 1972-1979. (The column totals in Table 2

are the data reported in -column “four in Table 1.) Table 2 shows

47/The existing structural differences between the MTS/WATS and PLS
markets are, however, highly time-specific. If present technological and
competitive trends continue, the structural differences between the MTS/WATS
and PLS markets may eventually become unimportant. At that point total RBR
deregulation of AT&T may be desirable.

48/The FCC decision in Docket 21402 found that MTS and WATS to be "like"
services. Whether MTS and WATS might be considered separate markets in terms
of the market boundary analysis of Section IV is not determined, however, in
this paper.

49/More comprehensive data including interstate revenues for non-Bell
carriers are not conveniently available. Nevertheless, more inclusive data
would not significantly alter the relative orders of magnitude shown in the
table.


-37-

the MTS price structure is unlikely to reflect opportunity cost.60/

The performance of the wholesale PLS market, however, differs from the
retail MTS market. Fron a market structure viewpoint, private line service
customers may consider the PLS offerings of AT&T's competitors. As a result
of the FCC's specialized common carrier decision,61/ private line customers

may now choose from a variety of PLS offerings provided by the specialized

—

60/In recent years, economists have attempted to determine from a static
welfare economics point of view the conditions where market price should not
reflect marginal cost. More specifically, recent work on the theory of
"Ramsey pricing" shows that welfare optimal pricing, i.e., prices derived by
maximizing a welfare function subject to a total revenue constaint, implies
that market prices should systematically deviate fron marginal cost. Among
various "Ramsey theorems" the relationship Cp; - me;)/P = [y/
(1+ d)IQ/E) where p, mc, and E, represent market price, marginal cost, and
price elasticity of demand for good or service i, respectively, and A is an
undetermined Lagrangian multiplier associated with the total revenue
constraint, suggests that the welfare-maximizing divergence of price from
marginal cost is, among other things, an inverse function of the elasticity of
demand for the commodity. Ramsey pricing rules assume that the firm
experiences increasing returns to scale or produces multiple outputs such
that common and joint costs must be allocated and recovered in the pricing of
each individual output. The classic modern reference to this growing
literature is William J. Batinol and David F. Bradford, “Optimal Departures
from Marginal Cost Pricing,” American Economic Review 60 (June 1970):265~
83.- A brief yet clear exposttion of the elements of Ramsey pricing is
provided by S. C. Littlechild, Elements of Telecommunications Economics
(Stevenage, U.K.: Peter Peregrinus Ltd., 1979), pp. 128-131. From a
regulatory perspective, applying Ramsey rules raises complex problems of
equity and measurement. Thus, is it "fair" for consumers having few
substitute alternatives (say, MTS users) to pay a larger markup over marginal
cost than consumers having competitive alternatives (say, PLS users)?
Moreover, can the marginal cost of individual services produced by a multi-
output firm, be estimated with sufficient precision to develop wel fare-optimal
tariffs? These difficulties among others have not been satisfactorily
resolved, notwithstanding the existing pricing constraint imposed by the FCC
in Docket 18128 that AT&T's tariffs for interstate telecommunications services
should be based on "fully distributed costs." These difficulties are reviewed
in Jerry B. Duvall, *pricing and Cost Allocation Issues in Interstate
Telecommunications Markets,” OPP Working Paper, forthcoming.

61/See 29 FCC 2d 870 (1971).


-23-

A. The Concept of Market-Specific Dominance

Implicit in most definitions of a dominant firm is the assumption that
the firm sells a single product or service that, fron the buyer's viewpoint,
resembles in most important respects the output of other competing firms in
the industry. In many cases, however, real-world firms produce multiple,
heterogeneous outputs rather than a single, homogeneous product or service.
Moreover, the markets for the individual products or services of a multi-
output firm may differ sharply in terms of structure and conduct.
Consequently, the concept of a dominant firm should be market-specific; the
firm may be dominant in one or several of its output markets but possibly non-
dominant in others.40/ The notion of market-specific dominance emphasizes the
importance of both demand and supply in assessing market performance. By
contrast, conventional concepts of dominance are implicitly firm-specific and
supply-oriented, i.e., such concepts emphasize the quantity of output supplied
to the market by a particular firm while placing less emphasis on the
characteristics of market demand. The significance of the market- specific
dominance concept is that. it shifts the focus of regulatsry policy away from
the dominant firm as an aggregate corporate or organizational entity per se
and toward the conduct of the firm in a specific market. If performance in a
particular market is satisfactory and can be reasonably expected to remain so,
then there is little justification for regulatory intervention even if the

firm is defined as dominant in a supply-oriented sense of the term.

\

ee

40/The concept of market-specific dominance introduced here parallels
recent theoretical analyses of natural monopoly discussed in Section If.
While the terminology "market-specific dominance” may be novel, the approach
itself is implicit in many anti-trust analyses of market conduct and
structure. The application of these concepts to regulatory policymaking,
however, is unique. Moreover, since the effects of rate base regulation are
not similar to those of conventional anti-trust remedies, the analysis must be
appropriately modified.


In terms of the recent literature, 4 natural monopoly is defined as a
special type of industrial organization where a single, multi-product firm can
produce the entire output of the industry more cheaply than a multiplicity of
independent firms.13/ If the cost function for a particular industry meets
this condition for a natural monopoly, then the entry of additional firms in
the industry would only increase the social cost of producing total industry
output. Moreover, government barriers to entry may not be necessary to
maintain the socially-optimal , cost-minimizing, natural monopoly market
structure. If in response to the threat of competitive entry the regulated
firm is permitted to set (Ramsey optimal) prices that maximize consumer
welfare, then the natural monopolist may under certain assumptions be
“sustainable,” i.@+5 invulnerable to “entry by competitors seeking simply to
duplicate the services provided by the natural monopolist .14/ If the
regulated firm is not allowed such pricing freedom, then government
restrictions on entry into the industry may be essential to avoid the waste of
resources that would otherwise occur as potential entrants attempt to compete

with the regulated natural monopoly firm.

13/More specifically, the cost function of a multi-output natural
monopoly firm is strict] subadditive. A cost function c(y) is strjctly
subadditive at output vector y ificly') > C(y) for any set of vectors y > 0
where ty! = ye See Baumol, "On the Proper Cost Tests for Natural Monopoly in
a Multiproduct Industry."

14/See William J. Baumol , Elizabeth E.. Bailey, and Robert D. Willig,
"Weak Invisible Hand Theorems on the Sustainability of Prices in @
Multi product Monopoly, “American Economic Review 67 (June 1977): 350-365 and
Jorn C. Panzar and Robert D. Willig, ree Entry and the Sustainability of
Natural Monopoly,” Bell Journal_of Economics 8 (Spring 1977):1-22.


-45-

decision.74/ Although AT&T may still attempt to shift costs in order to

increase total profits, this aggregated FDC methodology will provide a

oT

74/From a legal and accounting perspective, the allocation of jointly-
used plant investment is inherently arbitrary. Thus, the selection of an
appropriate allocation rule or formula should be determined with care. For
example, a "relative use” rule will be to some extent a function of the prices
of the services using the jointly-used plant. Thus, consideration of such
interdependencies is required when choosing a particular allocation rule. As
discussed in footnote 60, economists have derived pricing rules that allocate
joint and common costs such that the recovery of such costs minimizes the loss
in welfare. The FCC, however, in its Docket 18128 decision did not officially
recognize such static welfare-maximi zing allocation principles. Instead, the
quasi-economic and accounting principle of "historical cost causation" was
selected by the FCC as the method for allocating joint and common costs in the
Bell System.

While accounting-type allocation rules for joint and common costs are
inherently arbitrary and without rigorous economic justification, such rules
may have significant economic implications. (For a recent theoretical
discussion of this point, see Ronald R. Braeutigam, "an Analysis of Fully
Distributed Cost Pricing in Regulated Industries," Bell Journal of Economics
(Spring 1980) :182-196.) Such allocation rules have Pp ayed a prominent role in
the "separation principles" used by the telephone industry for toll settlement
purposes between independent and Bell System operating companies. Traditional
separations "allocators” such. as Subscriber Line Use (SLU) and Subscriber
Plant Factor (SPF) have been "revised" over time to reflect evolving changes
in the Jocal and tong distance telephone markets, political compromises
between federal and state regulatory authorities, and the Bell System's
corporate objectives. The important point fs that such arbitrary cost
allocation rules either between political jurisdictions (separations) or among
interstate services (FCC fully distributed cost methodol ogy) affect the market
conduct of telecommunicat ions carriers. While imperfect, such cost allocation
procedures, if subject to publ ic inspection, unambiguous in concept and
application, and reasonably auditable, can be used as regulatory tools to
constrain some aspects of dominant carrier conduct. Thus, @ simplified, fully
distributed cost (FDC) methodology based on existing separations data is a
useful regulatory tool for preventing arbitrary reallocations of cost by AT&T
for purposes of inter-service cross-subsidization. The application of such a
simplified FDC methodology is presently proposed by the FCC's Common Carrier
Bureau in Docket 79-245 and, if adopted by the Canmission, will provide an
effective regulatory togl for controlling inter- service cross-subsidization
during the transition phase toward a more competitive teleconmunications
industry. With sufficient entry in the MTS market, the need for regulatory
intervention in general and arbitrary cost allocation rules in particular will
diminish.


-~47-

force AT&T to maintain low prices and forestall entry for a longer period of
time than may be dictated by their own optimal pricing strategy.

The cross-subsidy issue is therefore of limited importance to the design
of regulatory policy for PLS markets in a post-Cost Manual world.76/
Certainly AT&T as a profit-maximizing firm will attempt to evade the
restraints of the Manual, but the official adoption and implementation of the
Manual would in fact prevent ad hoc regulatory attempts to protect its

competitors.

76/Further questions arise if we consider the long-run impact of PLS
regulation on cross-subsidization. One approach to the problen would be to
extend the Averch-Johnson model to a firm constrained by a cost allocation
procedure. The production technique and the output Jevel of the regulated
firm would depend on the nature of the cost allocation and whether or not a
rate of return constraint was applied to the competitive-like service. A
first step in this direction is provided by Ronald Braeutigam, "The Regul ation
of Multiproduct Finns: Decisions on Entry and Rate Structures". Braeutigam
applies an Averch-Johnson model to a multiproduct firm subject to overall rate
base regulation. Not surprisingly, he finds that the entry of new firms
producing near-substitutes to one of the firm's two regulated products may or
may not improve economic efficiency, depending on features of the demand and
cost functions. In light of these results, it is most likely that an
extension of this model to include the effect of PLS regulation would
similarly yield indeterminate results. More importantly, the validity of an
extended Averch-Johnson model to the cross-subsidy issue is highly dubious,
since AT&T will face increased competition for MIS services thereby
undennining its ability or incentive to cross-subsidize private line services.


-10-

litigation rather than the satisfaction of consumer needs.19/ In brief,
viewing the practice of rate base regulation more broadly as a dynamic
institutional process and not primarly in terms of static equilibrium models
highlights the limitations of both the Averch-Johnson and the more recent
natural monopoly literature for guiding the formulation of telecommunications

regulatory policy.

C. Deregulation as an Alternative to Rate Base Regulation

Given the possible incentives for distorted market performance as well as
the substantial administrative costs of rate base regulation, some economists

have strongly urged deregulation as an alternative to continued rate of return

19/For further analysis and criticism of regulation as an institutional
process, see Bruce Owen and Ronald Braeutigam, The Regulation Game: Strategic
Use of the Administrative Process (Cambridge, Mass.: Ballinger Publishing Co.,
1978).