-16-

Table 3: Access Demand Elasticities cited in

Analysis of the Effects of Federal Decisions on

Local Telephone Service a/

Elasticity Estimates

Study State _(Co.) Customers Short Run Ii Year Long Run
Egan AR, KS,MO,OK, TX
(Bel1) Business -.01 -.03 ~-.07
Egan AR, KS,MO,OK,TX
(Bell) Residence -.01 -.03 ~.04
Doherty NY (Bell) All -.04 -.09 -11
Carr NY (Rochester) Business NA -.05 NA
Carr NY (Rochester) Residence NA ~.04 NA
DRI CT (Bell) Business -.04 -.13 -.15
DRI CT (Bell) Residence ~-.03 -.08 -.08
Gearity TN (United) All -.24 7.24 -.24
Gearity VA (United) All -.22 -.22 ~.22
Perl National Survey
(1970 data) Residence NA NA ~.09
Perl b/ National Survey
(1980 data) Residence NA NA -.03
Reinking UT (Bell) All -.04 -.04 -.04
Miller MI (Bell) All -.08 -.08 -.08
Alleman b/ National, Cities Residence,
~ FR NA NA -.17
Alleman b/ National, Cities Residence,
FR&MS: NA NA -.02
Feldman National, States Residence NA NA -.05
Davis et al Bell Systen All NA -.02 -.08
Mahan NC (United) Residence NA NA 10)
Heidt NE Tel. (Bell) Residence -.04 NA -.20
a/ Source: Analysis of the Effects of Federal Decisions on Local Telephone

Service, A Report after Inquiry in CC Docket 83-788, Common
Carrier Bureau, December 9, 1983, Table 2, page 25.

b/ The estimating equations used by the authors of these studies make some
provision for the availability of substitutes for flat rate service such

a local measured service, where available.

Theoretically this should

improve their usefulness as measures of the elasticity of demand for

access,


-37-

Subsidies, if deemed necessary, should meet two criteria, First, they
should be raised in as nondistorting a way as possible, 56/ not through

general tax revenues (the ideal) than perhaps by an addition to customer

access line charges. Second, financial payments or lifeline rates should be

made available to those who need them, not to everyone. The difficulty of
identifying those who should be eligible for subsidies--whatever form they
take-~is often magnified unduly by those opposed to targeted programs. We

believe it would be both fairer and far less expensive to formulate a program

aimed at low-income individuals rather than high-cost areas.

56/ All taxes or similar subsidy sources involve some distortion - in the
Sense that the tax leads consumers to choose among goods and activities ina
different way than they would in the absence of the tax. A tax is relatively


-33-

Consider the application of such equity principles to the consumption of
autanotive services. They imply that these services are inequitably priced
because per-unit costs are higher for an individual who does little driving
canpared to an individual with the same car who drives a lot. Similarly,
autamobiles are inequitably priced because their prices constitute a larger
percentage of incane for a person with a small incane canpared to an
individual with a large income. It has been suggested that it is unfair for a
person who makes no long distance calls to have to pay a long-distance access
charge. This is analogous to arguing that people who do not drive their cars
long distances should not have to pay the full cost of their cars. Of course,
application of the same principle also implies that local unmeasured service
is very unfair since average costs for a person who only uses his phone in an
emergency are much higher than for a person who talks all day, a conclusion
that is not often drawn by the advocates of the current system.

Note that traffic-sensitive autamotive costs are higher in some parts of
the country than in others. In the North, for example, snow tires are often
needed for winter driving, whereas in the South they are not. Should people
in the South therefore be canpelled to subsidize snow-tire purchases by
Northerners? If they are so compelled, one thing we can be sure of is that
many more Yankee autos will be equipped with snow tires. Of course if
Southerners must subsidize Northerners because the North is cold, "equity"
demands that Northerners be canpelled to subsidize Southerners because the

South is hot!


Devlin, Susan J. and I, Lester Patterson, "Toll Usage" in Linda Brandon,
(ed.), The Effect of the Demographics of Individual Households’ on their
Telephone Usage (T9381).

Doherty, A. Noel, Testimony Before the Public Service Commission of the State
of New York on behalf of New York Telephone Co., submitted in CC Docket No.
83-788 by the New York Department of Public Services (1983).

Egan, Bruce L,, Testimony Before the Arkansas Public Service Cammission, and
Testimony before the Public Service Commission, State of Missouri, submitted
in CC Docket No. 83-788 by Southwestern Bell.

FCC, Common Carrier Bureau, “Analysis of the Effects of Federal Decisions on

Local Telephone Service", A Report after Inquiry in CC Docket No. 83-788,
December 9, 1983.

Feldman, J. "A Preliminary Cross Sectional Analysis of Services,” unpublished
paper (1976).

Friedman, Milton, "The Methodology of Positive Econanics," in Readings in
Microeconanics, William Breit and Harold Hochman (eds.) (1971).

Gearity, Gail A., Testimony Before the Tennessee Public Service Commission, on
behalf of United Inter-Mountain Telephone Company, submitted in CC Docket No.
83-788 by the Tennessee Public Service Commission (1983).

Gearity, Gail A., Testimony Before the Virginia State Corporation Canmission,
on behalf of United Inter-Mountain Telephone Company, submitted in CC Docket
No. 83-788 by the Virginia Public Service Commission (1983).

Griffen, James M., "The Welfare Implications of Externalities and Price
Elasticities for. Telecanmunications Pricing," Review of Economics and
Statistics (February 1982).

Heidt, P., “New England Telephone Residence Basic Service Demand," unpublished
paper (1979).

Hirshleifer, Jack, Price Theory and Applications, 2d ed., Prentice Hall, 1980.

Johnson, Leland L., "Why Local Rates Are Rising," Regulation (July/August
1983).

Kahn, Alfred E., “Sane Thoughts on Telephone Access Pricing," National
Economic Research Associates Reprint (1983).

Littlechild, S.C., Elements of Telecanmunications Econamics (1979).

Mahan, Gary-P., "The Demand for Residential Telephone Service," Michigan State
University Public Utilities Papers (1979).

Miller, Richard C., Direct Testimony on Behalf of Michigan Bell Telephone
Campany before the Michigan Public Service Commission (1983).


-10-

recognized, the task of designing an efficient system of subsidies is by no means
simple. 10/ On the other hand, the alternative to selective subsidies

targeted to desired nonsubscribers is a blanket subsidy to all (paid by

whom?). This kind of approach is extremely wasteful in that most of the

people subsidized would have subscribed without the subsidy. Unless subsidies
are funded with government revenues, they will need to be financed by

increasing user charges. That will cause a misallocation of resources and
losses of economic welfare. 11/ These costs must be balanced against the
benefits of having additional subscribers on the network. 12/

At low levels of penetration, it might be possible to argue for
government intervention to internalize consumption externalities associated
with telephone access. Whether such intervention actually represents sound
public policy would still depend on how much it costs, the magnitude of the
external effects and the extent of private internalization efforts. At
current high levels of penetration and faced with the prospect of relatively
modest short-term cost increases, the externality argument supplies at best a
weak basis for opposing rate reform. Recognition that the current system of
cross-subsidies will become increasingly unsustainable in a competitive

enviroment further weakens that basis for opposition to change. Finally, if

10/ See Comments (in passim.) throughout the Joint Board proceeding (CC
Docket 80-286). Several commenters remarked that the proposed subsidy plan
would reward inefficiency and penalize efficient operations. Many also noted
the tenuous connection between subsidy and need in the proposed plan.

1l/ James M. Griffin (1982) estimates the econanic welfare losses associated
‘with current inefficient pricing practices to be on the order of $1 billion
per year. He (p. 66) concludes that "the existing degree of cross
subsidization of local service by long-distance service cannot be justified by
welfare econamics." See also footnote 24, below.

12/ For some estimates of the costs involved in extending a subsidy to
Broader groups see Lewis J. Perl (1983), Figure 14.


=20-

the price coefficient picks up some of the influence of changes in long-
distance rates, among other things. That will not affect the predictive
capability of the model as long as the underlying demand structure remains the
same. Implementation of access charges will, however, result in lower long-
distance rates -- an important change in the underlying structure of demand
which operates in the opposite direction from the effect of higher access
charges. Lower telephone equipment prices have a similar effect. In Perl's
model the price coefficient must, therefore, overstate the effect of access
charges and that coefficient is, of course, already close to zero. 28/ That
would not contradict the law of denand. It would simply imply that there are
very few people at the margin at current prices. In this regard it is
interesting to note that the “consensus” demand elasticity estimate given by
Lester Taylor (1980, p. 170) in his survey of the telephone demand literature

is constructed with near-zero as the lower boundary. 29/

28/ Indeed, in a statistical sense, it may well be zero, since recognition of
upward bias leads one to question results of tests for statistical
significance. If a confidence interval were constructed for an unbiased point
estimate at a conventional level of confidence (say 95 percent), It might well
include zero. In that case the null hypothesis that small price changes have
virtually no effect on demand could not be rejected.

29/ Taylor's “highly subjective” estimate is that the true elasticity of
demand for access lies between -0.01 and -0.19. (Taylor, 1980a, p. 170) See
also Table 3, infra.


-38-
VI. Summary

Consumers pay all the costs of providing telephone service. That is
true now and it will be true if the FCC's access charge plan or any other
pricing scheme is implemented. Under current practice below-cost prices for
local telephone service are paid for by above-cost prices for long-distance
service and for all other goods and services whose production and distribution
entail use of long-distance service. That implies that when someone pramises
to keep the price of local telephone service fran rising, he is also promising
to keep the prices of long-distance and other goods and services from
falling. It also implies that a person who makes no long-distance calls is
not necessarily being subsidized under the current system, for the overcharges
on all other goods and services consumed may more than offset the difference
between the actual cost of access and the price actually paid.

Because consumption varies with incame, it is probably true that there is
an incane redistribution fran higher to lower income consumers occurring under
the current system. That redistribution occurs because surcharges are
embodied in the prices of virtually all goods and services and higher incane
individuals, up to a point, purchase more goods and services. Note, however,
that these redistributive benefits are currently being produced in an
extremely inefficient way (not to mention their being "bestowed" quite
arbitrarily). 5Y/ The same benefits could be provided to needy individuals at
far less cost or, alternatively, much larger benefits could be provided if

57/ As Kahn (1982, p. 8) argues, "There are consumers who want to make a lot
of calls in an extended area at no extra charge, and there are others who
happen to live in the country, or on the borders of local calling areas, whose
equally short-distance calls are subject to inflated toll rates: to imply
that the interest of both of these would be similarly adversely affected by a
more efficient pricing system is ridiculous."


I. Introduction

This paper addresses the question of whether recent pricing reforms
undertaken by the Federal Canmunications Cammission (FCC) constitute a threat
to "universal" telephone service. ‘The paper is organized as follows: Section
II provides legal and historical background on the universal service policy
goal and examines conceptual issues surrounding the definition of universal
service and possible economic rationales for government intervention to bring
it about. Section III analyzes demand for telephone access and surveys recent
econometric evidence on the sensitivity of demand to changes in prices and
other demand-influencing factors. Section IV describes the price changes
attributable to recent regulatory decisions, in particular those related to
the FCC's plan to implement a system of flat access charges to cover
nontraffic-sensitive costs of providing telephone service. Net price effects
of these policy changes are not large and given that reforms are to be phased
in over several years (during which other factors will be operating to
increase demand) and that demand for access is estimated to be relatively
insensitive to price changes, our conclusion is that any effects on telephone
subscribership are likely to be quite snall. Section V considers policy
issues and examines alternative means for mitigating any adverse effects that
might occur as a result of implementing a system of access charges. Section

VI contains a brief summary of principal conclusions.


-31-

Purchase the products of businesses that are able to reduce their costs by
bypassing the public switched network, but may be wasteful fran an econony~
wide perspective if motivated by artificially high prices rather than real
cost savings.

Congress perceives that bypass is the real threat to universal service,
but instead of deterring uneconanic bypass by confronting decisionmakers with
prices that accurately reflect costs, some members of Congress Propose to tax
bypass technologies. On the one hand, that solution will not work given
sufficiently large loopholes in the tax proposal. 48/ On the other hand, if
the solution "works," then we are really in trouble. Technical advance is the
primary reason we have low-cost, high-quality, widely available telephone
service. Technical advance does not occur in a vacuum. The extent and
direction of technological progress reflect prior investments in research and
development, which in turn reflect the structure of incentives embedded in
market prices, A9/ Technical advance is like any other good--make it more
expensive and people will demand less of it; reduce the reward to investments
in new technology and people will invest less in the activity. Congress in
essence proposes to preserve universal service by killing the goose that
figuratively laid the golden egg. As Leland Johnson (1983, p. 50) has
remarked:

Such a clear-cut case of penalizing the development of new and
lower-cost technologies raises Major issues of national
econanic policy.

48/ See the canments of the FCC in its letters to Senator Goldwater on S.
1660 (October 31, 1983) and to Representatives Broyhill and Ritter on H.R.
4102 and H.R. 4285 (Decenber S, 1983),

49/ See Nina W. Cornell et. al. (1980).


-17-

Table 4: Estimates of Price and Income Elasticities of
Demand for Access fran: Lester D. Taylor -
Telecormunications Denand: A Survey and Critique a/

Ab/
Price Elasticity
Class of Service Basic ¢/ Income Type
Qustomer Dependent: ‘Connection Service Elast- of
and Study Variable Charge Charge icity Data
Residential
Alleman main stations NE 0.17 0,56 3 Cities, U.S.
Feldman main stations
plus
extensions NE 0.05 0.54 CS: States, U.S.
Perl telephone
availability 0.12 0.08 0.15 CS: Households, U.S.
Rash main stations NE 0.11 0.61 TS: A, Ontario
and Quebec
Waverman main stations NE 0.12 0.15 TS: A, Ontario
and Quebec
Business
Waverman main stations NE 0.09 NE TS: A, Ontario
and Quebec
Residential &
Business
Combined
Davis total tele-
et al. phones less
residence
main stations NE 0.08 0.39 TS: A, Bell
System, U.S.
Waverman main stations -0.04 0.06 0.56 TS: A, Sweden

Symbols: NE: not estimated; CS: cross-section; TS: time series; At annual

BY
Elasticity
Type of Demand
Service Monthly ‘Incane
Connection Charge Service Charge
Access -.03 (*0,01) -0.10(*0.09) 0,50 (70.10)

Bf Ballinger, Cambridge, 1980.

‘/ page 80, Table 3-1. Includes non - U.S, data,

‘/ Note that this includes both access and a certain amount of local calling, and is
therefore an upwardly biased measure of the elasticity of demand for access alone. Perl's
specification includes the availability of local measured service, which partially
corrects for this problen.

@/ page 170, Table 5-1. Taylor provides the following explanation of these numbers:
“These estimates refer to long-run, steady-state elasticities. [...] The estimates
reflect my own interpretation of the empirical record (for both foreign countries and the
United States) and are thus highly subjective. The numbers in parentheses are subjective
standard errors.


-23-

the useful economic lives of these investments are shorter -- for whatever
reason.

Depreciation is a real cost of doing business, and as such, must be
recovered by a campany if it iis to stay in business. Investors will find a
canpany an unattractive investment if it fails to cover these costs, whether
due to bad management or regulatory disabilities. The ultimate result of
inadequate depreciation will be an inability to replace old or obsolescent
facilities with newer, technologically up-to-date equipment. ‘That result,
while possibly permitting lower prices in the short term, will threaten the
continued. availability of high quality service. Because it thwarts the
introduction of new technologies, it may actually result in future prices to
consumers that are well above what would have been possible under more
enlightened procedures. In short, excessively long depreciation schedules
only seem to pramote consumer welfare by keeping prices low, but they imply

higher prices and poorer service in the future. 34/

B. Effects on Costs

Staff of the FCC's Common Carrier Bureau has sought to estimate the
general magnitude of the price changes associated with recent federal
regulatory decisions. 35/ In addition to imposition of access charges and
more rapid rates of capital depreciation, the Staff also considered the

effects of changes in the accounting for costs incurred in the provision of

34/ That depreciation rates were excessively long in at least one instance is
suggested by ATT's write-off of a substantial portion of its CPE assets in
late 1983. In econanic terms they were simply not worth their book value.

35/ See FCC, Common Carrier Bureau (1983).


-19-

alternatives (measured service, lifeline options, etc.) 26/ rather than
dropping off the network. QOnitting the prices of relatively close (and less
expensive) substitutes thus leads to an overstatement of the elasticity of
denand for simple access.

A similar upward bias results fran failure to account explicitly for the
effects of changes in prices of closely complementary goods and services, in
particular telephone equipment and long-distance service. 27/ Lewis Perl's
studies are illustrative in this regard. Perl finds that demand for access
has became more price inelastic over time. The reason is that other demand-
influencing factors (largely omitted from Perl's models) operated in the sane
direction as price changes during the interim between study sample periods
(viz., the decade of the seventies). Changes in most demand-determining
factors increased demand, and these canbined with lower prices imply that a
reduction in measured elasticity should be observed, as discussed above. If
there had been no changes in the underlying structure of demand between the
two sample periods, the initially estimated price elasticity coefficient would
provide a biased measure of the actual effect of price changes (because it
reflects the effects of omitted variables as well), but would nevertheless
generate accurate predictions because of the (assumed) stability of the
underlying demand structure.

In Perl's new study lonj-distance rates are not included as a factor
affecting the demand for access, although there are good reasons to believe
there is a strong canplenentary relationship between the two. ‘This means that

26/ Measured service offerings are available to about 70 percent of the
residential subscribers served by Bell operating companies.

27/ Complementary goods are goods always or often used in conjunction with
each other, e.g. - tennis racquets and tennis balls. A drop in the price of
one will increase the demand for the other.


-32-

C. Equity Considerations

Alfred Kahn (1982, p. 7) has observed that:

Clearly there are possible areas of public policy in which
conceptions of fairness may conflict with econanic

efficiency. But it is by far the greater wisdam to recognize
that, for the most part, the major departures fran econanic
efficiency in our public policies today are also demonstrably
unfair; and that, for the most part, movement in the direction
of econamic efficiency is also compatible with increased
fairness. It is fair, as a general proposition, to impose
costs on people insofar as they impose costs on society.

While the FCC's access charge plan is a “movement in the direction of
economic efficiency" and attempts “to impose costs on people insofar as they
impose costs on society," some have nevertheless claimed that the plan is
inequitable. Their argument is premised on the observation that since users
differ in incane, a flat fee constitutes a larger percentage of incame for the
poor canpared to the rich and is thus regressive, as is any lump sum tax. 50/
Note that on this view all prices not scaled to incame differences are
regressive. Any price represents a larger proportion of a low income than a
high one. Consumers may also differ in their use of the service, so that even
if everyone had equal incomes, there would still be an equity problem because
consumers who use the service more face a lower average charge, the flat fee

being spread over a larger number of units. 51/

50/ For a simple analysis, see Steven T. Call and William L. Holahan (1983,
p. 445). °

51/ The principle has been given humorous expression by Calvin Trillin
(1983), who notes that "I bought my tuxedo in 1954, when I was a thrifty young
undergraduate, because I had added up the number of black-tie events I would
have to attend during college, divided the cost of a tuxedo by that number and
concluded that I would be better off buying a tuxedo than renting one... As it
turned out, there have been a number of occasions to wear the tuxedo since
graduation... and every time I wear it the cost per wearing decreases. This
New Year's Eve, for instance, wearing my tuxedo is going to cost me only about
48 cents..."


-14-

This is an important point in that under the FCC's plan, access charges
would be phased in over several years. 18/ To the extent that other factors
affect demand and their effects are in the opposite direction fran access
charges, they act to mitigate the effect of access charges. Rising prices for
energy and other substitute goods (postage, time), falling prices for
telephone instruments, long-distance service and other complementary goods
{home computers, alam systems, shopping services), rising real incomes, an
aging population and other factors all operate to offset the effect of access
charges gradually being phased in. Failure to take the effects of these other
demand-influencing factors into account will result in an understatement of

the subscriber penetration levels actually likely to prevail in the future. 19/

B. Empirical Estimates of Demand Elasticity Paraneters

There are a large number of studies which attempt to estimate the

parameters of the telephone demand relation empirically. 20/ These studies

18/ See Memorandum Opinion and Order in CC Docket No, 78-72, Phase I (Second
Reconsideration), Released February 15, 1984 (FCC 84-36).

19/ Empirical evidence on the effects of price changes, while not ideal, is
auch more highly developed than evidence on the importance of other demand
influencing variables. The temptation to rely solely on price information,
simply because it is the most readily available, must be resisted if
reasonable forecasts of the effects of restructuring telephone rates are to be
made. This should be kept in mind as the next section is read.

20/ Studies submitted in CC Docket No. 83-788 (the so-called Michigan
proceeding) include: Bruce L, Egan (1983), A. Noel Doherty (1983), Michael T.
Carr (1983), Data Resources, Inc. (1983), Gail A. Gearity (1983), Lewis J.
Perl (1978 and 1983), Richard Reinking (1983), Charles River Associates
(1983), Richard M. Oveson (1983), Laurits R. Christensen (1983), and

Richard C. Miller (1983). Other studies include: J. H. Alleman (1977),

J. Feldman (1976), B. E. Davis et. al. (1973), Garry P. Mahan (1979) and

P. Heidt (1979). The demand literature has been surveyed by Lester D. Taylor
(1980) and Gary W. Bowman and Wayne A. Morra (1983).


-6-

Table 2: Development of Residential Telephone Service
in the United States, 1961 - 1981 1/

Percent Households Percent Households
with Telephone with Telephone

Year Service Year Service
1981 96 1970 92

80 96 69 90

79 98 68 89

78 97 67 88

77 96 66 87

76 95 65 85

75 94 64 83

74 94 63 81

73 94 62 80

72 92 2/ 61 79

71 93

1/ Source: Federal Communications Commission, Statistics of Common

Carriers, various years, Table 6. Original source, American Telephone
and Telegraph Co.

2/ 1972 and earlier years exclude Alaska and Hawaii.


-29-

B. Efficient Pricing and Network Bypass

Econamic theory provides guidance about the best (i.e., econamic
welfare-maximizing) method for covering the cost of telephone service. 43/
Cost should be covered by pricing services above their marginal costs in
inverse proportion to the elasticities of demand for the services. 44/ Since
access costs are relatively insensitive to actual usage and since demand for
access to exchange facilities is less elastic than demand for usage, it is
efficient to cover costs through flat fees for access and usaye-sensitive
charges that closely reflect marginal costs of usage along different output
dimensions (distance, length, time of day). 45/ The FCC's access charge order
would substitute flat access charges to recover nontraffic-sensitive costs for
a system that attempts to recover those costs through usage-sensitive charges
that greatly exceed marginal costs. The FCC's proposal is thus a move toward
more efficient pricing.

Those who oppose econanically efficient pricing generally fail to
recognize that failure to price efficiently will make most users worse off.
Socking it to the big guys always sounds good to the little guys until it is

pointed out that attempting to sock it to the big guys will end up costing the

43/ See William J. Baumol and David F. Bradford (1970).

44/ This assumes no lump-sum taxes are permitted and that cross-elasticities
‘Of demand among different services are zero. If the relevant cross-
elasticities are nonzero, the inverse elasticity rule is not applicable, but
an analogous rule may be derived. See Baumol and Bradford (1970, pp. 266-
267).

45/ The term "efficiency" is used here in its technical econamic sense; that
is, a pricing mechanism is efficient if it maximizes consumer welfare, given
the initial distribution of incane.


-26-
ve Policy Issues
A. Effects of Competition

The procanpetitive policies for telecanmunications that have been
developing at the FCC and elsewhere in government over the past decade have
been undertaken to increase the econamic welfare of consumers. Recent
discussion in Congress and among state authorities has focused almost
exclusively on costs--and primarily on redistribution of existing costs, some
of which might not even be classified as costs in economic terms. 38/
Reorganization of the telephone system along more canpetitive lines will not
be costless, but there are reasons to believe that it will generate
nonnegligible benefits for consumers.

Prices that reflect costs allow people to make choices in accordance with
the costs they actually impose on society in terms of alternative resource
uses foregone and the benefits they expect to receive. That pranotes
maximization of the economic benefits obtainable fran use of society's scarce
resources and is the basis for the United States' national market-canpetition
policy. Telecammunications was long exempt fran that policy because it was
supposed that econanies of single-entity organization dictated a regulated
monopoly industry structure. The judgment has now been made, at least
implicitly, that those econanies are insufficient or their existence

insufficiently tested to warrant maintenance of the old structure. Dynamic

38/ In econanic terms the real cost of any good is the value of what must be
sacrificed in order to obtain it. The cost of a decision is the opportunities
foregone if the decision is made. Costs that have already been incurred
cannot be affected by present decisions; they are sunk costs, and hence
irrelevant to decisonmaking.


universal service. Vail's "some sort of a connection. . . within reach" can

mean a lot of things. Do pay phones nearby count? Should a distinction be
drawn between persons who voluntarily "choose" not to subscribe and persons
who are "forced" to drop or forgo service because of higher prices? More
fundamentally, can such a distinction actually be validly drawn? If a
consumer refuses to subscribe when offered the option of paying a nominal
access charge and higher per-call charges, has that consumer been forced off
the network or denied access? 3/

In this paper access is defined in terms of a household's first
on-premise connection to the network. On that definition a pay phone in the
hallway of a roaming house or college domitory does not provide access to the
telephone network, although there is clearly a sense in which that is
precisely what it does, A "lifeline" service providing dial-tone and a
limited number of local calls for a fixed charge does provide access. ‘Thus
defined, the level of access to the telephone network in the United States is

very high indeed. As illustrated in Table 1, it averages well above 90

3/ The difficulties inherent in this issue require an understanding of the
economist's notion of consumer surplus. Roughly, this is the total value of
telephone service left to the consumer after he has paid for the calls
actually made. It is a measure of the maximum he would be willing to pay for
the right to make calls. As per call prices rise, the "surplus" shrinks, and
if that surplus becomes zero or negative the customer will drop off the
system. The fact that the consumer could stay on the system (while making
fewer calls) for a smaller total outlay is irrelevant. Under the new
conditions, heing on the system is less valuable to him. The issue lies in
the consumer's valuation of the service that is offered, not in whether he
could continue to receive access, but less service, for the same or a snaller
total outlay. For a brief but useful discussion see Lester’ D. Taylor
(1980b). See also Lewis J. Perl (1983), pp. 19-20.


II, Universal Service

A. Legal and Historical Background

The term "universal service" appears in no public law and there is
no authoritative source defining precisely what it means, let alone how it
might best be achieved. Within the telephone industry it is a shorthand

expression generally used to refer to Title I of The Communications Act of

1934, ‘That title requires regulation "to make available, so far as possible,
to all the people of the United States a rapid, efficient, Nation-wide, and
world-wide wire and radio canmunication service with adequate facilities at
reasonable charges." 1/

In simple terms universal service might be taken to mean that every
household has, or readily could have, convenient to its premises, the ability
to make or receive telephone calls. That is what the term meant to Theodore
Vail, the man who coined it in 1910. He believed that "some sort of a
connection with the telephone system should be within reach of all." 2/ In
modern discussions the issue is usually framed in terms of whether an
individual has "access" to the telephone network. Bridger Mitchell (1982)
notes that a binary view of access -- an “either you have it or you don't”
conception -- presumes a definition of “access." In the above definition, the
words "has," “readily could have" and "convenient to its premises" obviously

admit some degree of flexibility into the definition of access and hence

i/ Title I, Section II, The Communications Act of 1934, As Amended, 47 U.S.C.
§ 151.

2/ The quotation is from AT&T's annual report for the year'1910. See
Alvin von Auw (1983, p. 5).


-15-

vary widely in quality, type and source of data utilized, theoretical model
specification and statistical estimation technique. Significantly, despite
these differences, the studies indicate almost unifomnly that demand for
access to the telephone network is highly insensitive to price changes (See
Tables 3 and 4). 21/ Moreover, there is evidence that demand has been
becaning progressively more inelastic over time. 22/

While existing estimates indicate a highly price~inelastic demand for
telephone service, there are good reasons grounded in statistical theory which
suggest that these estimates still probably overstate the actual degree of
price sensitivity. This strengthens the basis for concluding that effects of
recent federal decisions on levels of telephone subscribership are likely to
be small. If, under assumptions which overstate the likely impact of those
decisions, the impact is nevertheless small, there is a strong analytical
basis for drawing that conclusion.

One source of upward bias in estimates of price elasticities arises
because demand for telephone service has been growing over time while the
price of service has been falling. In price-theoretic terms, the demand curve
has been shifting outward to the right at the same time there have been
movements downward along that demand curve. This implies that estimates based

on data fran more distant historical periods will overstate the actual current

21/ Estimates range from 0 to -0.24, with most of the estimates falling below
=-0.09. As the FCC Staff concludes in its report of findings in Docket No.
83-788 (1983, p. 28), "Those studies using the best and most recent data and
having the best specified theoretical framework yield estimates at the lower
end of this range."

22/ On the basis of 1970 data, Perl estimated an elasticity of -0.09. On the
basis of 1980 data, he found that elasticity had fallen to -0.03. As Perl
notes (pp. 13-14), there are good theoretical reasons to expect the elasticity
to have fallen as penetration increased.


percent for the nation as a whole and for certain states approaches 100
percent. The goal of universal telephone service has been substantially
achieved in the United States. 4/

Table 2 shows how telephone penetration rates in the United States have
grown over time. The growth and current high level of telephone
subscribership can be accounted for economically in terms of increases in both
supply and demand. On the supply side, continuous improvements in technology
have gradually reduced the real costs of telephone service, extension of
service to rural areas has been promoted by governmental loan subsidies and
local residential service (including access) has been funded in part by
overcharges on long-distance calling. 5/ On the demand side, changes in
virtually all demand-influencing factors have been in a direction increasing

demand (The telephone demand relation is discussed in Section III).

B. Economic Rationales for Public Policies to Promote Universal Service

There are two econanic rationales that might justify government
intervention to promote a level of telephone subscribership greater than that

which would occur under a regime in which consumers pay prices that reflect

4/ For penetration data, by state, based on the U.S. Census (1980) see
Lewis J. Perl (1983), Figure 24a. Our allegation in the text that universal
service has been substantially achieved in the U.S. should not be taken to
imply that this is the economically efficient level of telephone
subscribership. The latter is achieved when the marginal social value of an
additional subscriber equals the jarginal social cost of adding that
subcriber. When these costs amount to many thousands of dollars per
subscriber, as is sometimes the case, it would not be surprising if the costs
of providing the service greatly exceeded the benefits.

5/ Jeffrey Rohlfs (1978) has estimated that the marginal cost of interstate
long-distance message services was about 30 percent of price in 1976.


-21-

Iv. Effects of Regulatory Decisions on Costs

A. Policy Changes

The most important policy change to be considered is that mandated
in the FCC's so-called access charge order in Rocket 78-72. 30/ In that order
the Commission calls for a restructuring of the way in which nontraffic-
sensitive (NTS) costs of providing telephone service are recovered. Hitherto,
about 25 percent of these costs have been recovered through usage~sensitive
charges paid by long-distance users. This meant that a person who made no
long-distance calls could avoid paying the full costs of his access line. In
particular, he could avoid that portion of the NTS costs allocated
(arbitrarily in econanic terms) to the federal jurisdiction and recovered in
usage sensitive long-distance overcharges. At the same time, customers who
made heavy use of long distance bore more than their fair share of access-line
costs. The FCC now proposes to cover these costs through a system of flat
(i.e., usage-insensitive) subscriber fees to be phased in gradually over five
years.

Whether the evolution of campetition in telecanmunications is attributed
to technological breakthroughs, altered regulatory perspectives, or both, the
consequences are the same. In a canpetitive environment prices for telephone
services will be driven toward costs (including a competitive return on

capital investment). That means that any subsidies, inappropriate

30/ MfS and WATS Market Structure (CC Docket No. 78-72, Phase I), 48 Fed.
Reg. 10319 (Mar. 11, 1983) (Third Report and Order), recon. 48 Fed, Reg. 42984
(Sept. 21, 1983), review pending sub_nan. NARUC v. FCC, No. 83-1225 (D.C.
Cir.), second recon. Memorandum Opinion and Order released February 15, 1984
(FCC 84-36).



Federal Communications Commission
Office of Plans and Policy

1919 M Street NW

Washington, DC 20554

OPP Working Paper Series.

The Effects of Higher
1 0 Telephone Prices on
Universal Service

March 1984

Kenneth Gordon
John Haring





-8-

hypothesis, but neither does it offer support for it. An explicit attempt to
test the hypothesis would seem to be indicated."

Recently Lewis Perl (1983) has carried out a limited test of the
externality hypothesis. His work suggests that there may be a very modest
consumption externality associated with telephone access at the local level,
that is, telephone subscribers in a particular locality may benefit in a small
way and up to a certain point fran increases in local network
subscribership. If govermmental internalization of these externalities were
necessary (private internalization efforts proving inadequate) and could be
cost-justified (problematic according to Perl), that would at most provide an
econamic rationale for intervention to internalize externalities at the local
ievel. Note also that attempts to internalize consumption externalities at
the local level would simultaneously operate to limit any similar
externalities that might exist over broader geographical areas. 8/ The reason
is that a subscription to telephone service provides "access" to the unified
local and interstate network.

Externalities by thenselves never justify government intervention.
Demonstrations that benefits fran intervention exceed costs are necessary to
justify intervention. Individuals can be expected to undertake activities
that generate external benefits without being subsidized whenever the private
gain they expect to reap exceeds the cost they must bear. In tems of
telephone access, this implies that the consumption externality, if it exists,

will be autamatically internalized whenever an individual deems that the

8/ An externality is internalized when a decision maker takes the relevant
cost or benefit into account in his decisions. This may occur as a result of
the goverrmment's altering the prices or other circumstances facing the
decision maker, or through private arrangements, some of which are discussed
in the text below.


-7-

costs of providing service. These are the existence of important external
effects and the political classification of telephone access as a "merit
good."

The externality argument as it is usually applied to telecommunications
posits the existence of important consumption externalities. 6/ A positive
consumption externality occurs when consumption of a product by one person
directly increases the economic welfare of others. The value to any
individual of being on the telephone network depends on the availability of
others to call (or be called by). In deciding whether to subscribe to
telephone service, an individual may not take the value to others of his ow
presence on the network fully into account. 7/ Hence, in certain
circumstances it could conceivably be socially efficient to subsidize access
to the telephone network. In particular, a subsidy can be justified on
externality grounds assuming two conditions are satisfied: (1) There are
individuals for whan costs of service exceed personal benefits and who,
therefore, would not subscribe without a subsidy, but whose presence on the
network is socially efficient when the external benefits are reckoned; and
(2) The external benefits exceed the costs of subsidization.

While the consumption externalities hypothesis is frequently cited in
support of subsidies to particular groups, there is little empirical evidence
to support it. Summarizing the extant literature in his 1979 treatise on
telecanmunications econamics, S.C. Littlechild (p. 182) concludes that the
evidence "is not sufficiently reliable to disprove the externalities

6/ See Jeffrey Rohlfs (1974), Roland Artle and Christian Averous (1973) and
Lyn Squire (1973).

J/ Ve stress the word "may". An important reason for subscribing to

telephone service is that people are aware that others may wish to contact
then.




-28-

service that would occur under cost~based pricing. Estimates of the
deadweight econanic welfare losses attributable to current inefficient pricing
practices are enormous. 41/

The uses for and benefits to be derived fran increased use of long
distance go far beyond personal calls, important as these are. Professionals
in many fields now rely extensively upon information made available by low-
cost long-distance telecommunications. Medical doctors can call up services
such as "Medline" and "Colleague" to obtain state-of-the-art diagnostic
information and the most recent research. The legal reference service called
"Lexis" provides the same kind of information for lawyers. Architects,
engineers and professionals of all kinds are using long-distance
canmunications to acquire information that enables them to supply better
service at lower cost. The canputer revolution is another source of greatly
increased demand for telecanmunications services, especially long distance.
Credit card companies, airline reservation systems and hotel/motel chains all
use telecanmunications-linked canputer facilities to benefit consumers by
reducing market. transaction costs.

As long-distance rates fall, these service benefits can be made available
on an increasingly widespread basis, including, in particular, to those people
who live in rural areas and who are allegedly harmed by more efficient pricing
of telephone services. 42/ We believe, to summarize, that there are important

benefits to be obtained fram promotion of canpetition in telecammunications.

AV/ In addition to the Griffen study cited earlier, Wharton Econanetric
‘Forecasting Associates (1983) recently sought to estimate the macroeconomic
impact of reforming current inefficient pricing practices. They estimate
average gains on the order of $9 billion per year during the. 1984-1988 period.

42/ Costs of providing exchange access may be higher in rural areas, but so
too are the benefits of lower prices for long-distance calling.


-27-

inefficiencies such as slowmess in innovating or in reacting to changes in
demand thought likely to characterize the old structure's prospective
performance have been judged to outweigh efficiencies of single-entity
organization. That the benefits of dynamic efficiency under campetition will
actually prove to be greater than forgone efficiencies of scale and
integration, of course, remains to be seen.

There is some recent direct evidence illustrating how competition affects
telecanmunications users. Deregulation of custaner-premise equipment and the
campetition that has grow in its wake have brought benefits in the form of
lower equipment costs and a wider variety of qualities and service features
fran which to select. A monopoly provider might have been able to offer these
options to consumers, but under monopoly new products were, in fact, slow in
coming and both new and old products were high in price. 39/ The speed with
which consumers are shifting to non-telephone canpany equipment is powerful
evidence of the benefits a free market can provide and campletely consistent
with what we know to be true about canpetition's generally salutary effects in
the rest of the econany. 40/

Long-distance provides another example -- still developing. The growth
rates of the “other” cammon carriers and resellers illustrate the advantages
many consumers attribute to lower priced alternatives. Current pricing
practices substantially overcharge for long-distance service -- particularly
AT&T services, That means that not only must consumers pay a large premium
for the long-distance calls they do make, the premium itself leads them to

forego benefits they would obtain fran the greater utilization of long-distance

39/ See Brock (1981), Chapter 9, pp. 234-253.

40/ See “The Big-and Bruising-Business of Selling Telephones", Business Week,
March 12, 1984, pp. 103-106.


Table 1: Telephone Penetration in the United States,
by State, December 31, 1981 1/

Percent Households Percent Households

with Telephone with Telephone
State Service 2/ State Service 2/
Alabama 87 Montana 95
Alaska 90 Nebraska 100
Arizona 95 Nevada 84
Arkansas 85 New Hampshire 99
California 100 New Jersey 108
Colorado 97 New Mexico 86
Connecticut 103 New York 97
Delaware 100 North Carolina 91
District of North Dakota 98
Columbia 103 Ohio 94
Florida 98 Oklahoma 96
Georgia 88 Oregon 86
Hawaii 98 Pennsylvania 99
Idaho 92 Rhode Island 98
Illinois 99 South Carolina 86
Indiana 92 South Dakota 92
Towa 95 Tennessee 88
Kansas 96 Texas 95
Kentucky 86 Utah 93
Louisiana 93 Vermont 101
Maine 98 Virginia 91
Maryland 99 Washington 90
Massachusetts 101 West Virginia 85
Michigan 98 Wisconsin 98
Minnesota 99 Wyoming 89
Mississippi 82
Missouri 94
United States 96

i/ Source: Federal Canmunications Canmission, Statistics of
Communications Common Carriers, 1981, Table 6. Original source,
American Telephone and Telegraph Co.

2/ Households with service are the sum of residence main, apartment
house PBX and residence service main telephones, and other residence PBX
systems. There tends to be a slight overstatement of the proportion of
households with telephone service.


-18-

elasticity. 23/ Those estimates are based on data that lie outside the range
of more recent experience. They were made (or, more precisely, the underlying
data were generated) during periods when prices were higher, demand was lower
and penetration rates wre lower. A price increase will have a different
effect depending upon the initial level of demand and the initially prevailing
price. The effect of a price change today will be smaller than it would have
been 15 years ago because the real price is lower today and the level of
demand is higher.

A more general source of upward bias in existing estimates results fran
misspecification of the empirical model. Some of the estimates are based on
models which relate subscribership to total charges rather than to charges for
simple access. 24/ Demand for access (the option of making or receiving
calls) is presumably less elastic than demand for local or long-distance
calling. Faced with higher prices, most consumers will economize on usage,
where that is possible, rather than forgo service altogether. Estimates of
elasticity based on charges for total service will therefore overstate the
elasticity of demand for access alone. Relatedly, when alternatives
(substitutes) for flat-rate service are included in the specification of
demand, the measured elasticity of demand for access falls. 25/ This suggests

that some people will respond to higher prices by selecting lower-cost

23/ For example, use of the Perl estimate based on 1970 data to gauge the
effect of price changes in 1980 would, given the magnitude of the elasticity
parameter actually measured using 1980 data, result in overstatement of the
likely effect by a factor of three.

24/ See Table 3, infra, and its footnote b.

25/ In Alleman's model the measured elasticity fell from -0.17 to -0.02 when
measured service offerings were included in the specification of the model.
Perl (1983) also finds that the availability of measured service reduces the
estimated elasticity of demand for access. See Figure 6, p. 17.


-35-

through efficient management or use of cost~minimizing technologies, including
substitutes for conventional telephone such as radio. Third and most
importantly, the proposed systen of subsidies is targeted to high cost areas
rather than low-incame households. ‘The research we have reviewed in this
paper suggests strongly that the threat to universal service, if there is one,
is that low-incane consumers will be forced off the system, not that consumers
in high-cost areas will have to pay higher prices. The transfers contemplated
in the proposed universal service fund (not to mention the current system) are
not as closely tied to recipients’ incomes as might be desirable. What has
becane of fairness when, for example, long distance callers in Maine~-
including the poor and the elderly--subsidize the phone service of those who
have recently retired to Florida? These inter-regional transfers have not
gone unnoticed in New Jersey, Illinois or Maine. 53/

Intergenerational transfers are just as hard to justify as geographic
ones. Interest groups which purport to represent the elderly claim that older
people who rely on the telephone primarily for security and health reasons
will be driven off the system by access charges. The elderly actually have a
significantly less elastic demand for telephone service than the population at
large and thus are among the least likely to drop off the system if prices
rise. 54/ To argue that the elderly are hanned by access charges ignores that

the elderly do slightly more than the average amount of long distance calling

53/ See the cawments of their telephone campanies and state public utility
commissions on subsidies to encourage universal service in the Joint Board
proceeding. (CC Docket 80-286.).

54/ See Lewis J. Perl (1983).


-36~

and would presumably do even more if the price were lower. 55/ Many elderly
people are separated fran their families and friends by long distances and
would benefit fran the FCC's access charge plan by being able to make and
receive a greater number of long-distance calls of longer duration.

There are elderly people who are poor, to be sure, but it is their
indigence rather than their age which argues for their support. Why support
for the poor should take the fom of below-cost telephone service rather than
dollars is not clear. That adverse effects on the poor justify keeping the
price to everyone below cost is bewilderingly naive, but as Bastiat noted long
ago, “the state is the great fictitious entity by which everybody seeks to
live at the expense of everyone else." Unless you are prepared to argue that
everyone's food, fuel and television set bills should be subsidized (by whom?)
because higher food, fuel and TV prices hurt the poor, you cannot convincingly
argue against access charges on these grounds.

A universally available subsidy such as we have currently built into the
basic system of charges to all consumers, is an excessively costly and
ultimately infeasible way of meeting the legitimate needs of those few whose
access to telephone service might be threatened by cost-based pricing. It is
excessively costly because to maintain it will require forgoing the benefits
of campetition and technical advance. It is ultimately infeasible because
eventually the subsidy-providing users, especially major users, will find ways

of escaping the systen.

55/ See the toll usage study by Susan J. Devlin and I. Lester Patterson in
Belinda Brandon (1981).


-24-

embedded and new station connections, the decision to phase CPE revenue
requirements out of the interstate jurisdiction, the detariffing of embedded
CPE and its transfer to AT&T, Joint Board recommendations regarding changes in
the separations manual and growth in the proportion of inter~ and intra-state
toll usage relative to total telephone usage. 36/ Mandated changes in
depreciation, CPE decisions, separations changes and imposition of access
charges all increase revenue requirements, while changes in the regulation of
station connections and the effects of a shift toward toll service reduce
them.

The FCC Staff's estimate of the cumulative monthly increase in
residential telephone exchange bills associated with these changes is $4.22 in
1984 growing to $8.28 by 1989. This represents a compound average annual
growth rate for residential telephone exchange bills of about 7 percent from
1983 to 1989. 1b place this figure in context, recall that the real price of
telephone service has been falling steadily over time. Using constant 1972
dollars, the relative price of service actually declined from $8.17 in 1960 to
$4.69 in 1981. Only one category of consumption goods had a smaller nominal
increase than telephone service during the inflationary 1970's and early
1980's (womens' clothing). While the consumer price index more than doubled
over this period, telephone service prices rose only 30 percent. The price
increases implied by recent federal actions thus do little more than "catch-
up" with inflation, if indeed they even do that. When they are put in this

perspective, it is difficult to believe that they are likely to do any

36/ A summary of policy decisions is given in Attachment 9 to the FCC Staff
Study. FCC (1983).




Mitchell, Bridger M., "Pricing Subscriber Access to the Telephone Network,"
Paper Presented at the Workshop for Local Access: Strategies for Public
Policy, St. Louis, September 14-17, 1982 (mimeo.).

Musgrave, Richard A, The Theory of Public Finance, International Student
Edition, McGraw-Hill, 1959

Oveson, Richard M., "Telephone Usage in Utah: A Consideration of Alternative
Offerings," submitted in CC Docket No. 83-788 by Mountain Bell, Northwestern
Bell and Pacific Northwest Bell (1983).

Perl, Lewis J., “Econanic and Demographic Determinations of Residential Demand
ior basic Telephone Service" National Economic Research Associates (March 28,
1 .

Perl, Lewis J., "Residential Demand for Telephone Service: Preliminary
Results of a New Model," Paper Prepared for The Central Services Organization,

Inc. of the Bell Operating Canpanies by National Econamic Research Associates,
Inc., (December 16, 1983).

Preece, Robert, "A Club-Theoretic Approach to Telephone Access Externalities,"
Unpublished Paper (1983).

Reinking, Richard D., "Access Price Elasticity," submitted to CC Docket No.
83-788 hy the Arizona Corporation Commission (1983),

Rohlfs, Jeffrey, "Economically Efficient Bell System Pricing," Bell Laboratory
Discussion Paper No. 138 (January 1979).

Squire, Lyn "Some Aspects of Optimal Pricing for Telecanmunications," Bell
Journal of Economics and Management Science (Autumn 1973).

Tannenbaum, M., Address before NARUC Convention and Regulatory Symposium,
Detroit, Michigan (November 17, 1983).

Taylor, Lester D., Telecanmunications Demand: A Survey and Critique (1980a).

Taylor, Lester D., "The Demand for Telecammunications: A Nontechnical
Exposition", in Michael A. Crew, (ed.), Issues in Public-Utility Pricing and
Regulation, Lexington (1980b).

Trillin, Calvin, "Wearing My Tux Costs Just 48 a Bash," Washington Post
(December 25, 1983).

von Auw, Alvin, Heritage and Destiny (1983).

Wharton Econometric Forecasting Associates, Impact of the FCC Access Charge
Plan on the U.S. Econany (1983).



References

Alleman, J.H., "The Pricing of Local Telephone Service," U.S, Department of
Commerce, Of fice of Telecaumunications, Or 77-14 (April 1977),

Artle, Roland and Christian Averous, "The Telephone System as a Public Good:

Static and Dynamic Aspects," Bell Journal of Econanics and Management Science
(Spring 1973).

Baumol, William J. and David FP. Bradford, "Optimal Departures fran Marginal

Cost Pricing," American Economic Review (June 1970).
can Sconomic Review

Bowman, Gary W. and Wayne A. Morra, “Demand for Access and Use of the
Telephone Network: A Critical Review of Literature," Report to GTE Service
Corp., submitted in cc Docket No. 83-788 by the Iowa State Commerce Commission

Brandon, Belinda (ed.), The Effect of the Demographics of Individual
Households on Their Telephone Usage (1981).

Brock, Gerald W., The Telecammunications Industry, The Dynamics of Market
Structure, Harvard, 1981.

Call, Steven T. and William L. Holahan, Microeconanics (1983),
—eeeconamics:

Carr, Michael T., Testimony Before the Public Service Canmission of the State
of New York on behalf of Rochester Telephone Co., submitted in CC Docket No.
83-788 by the New York Department of Public Services (1983),

Charles River Associates, "The Demand for Local Telephone Services Upon the
Introduction of Optional Local Measured Service (IMS)," Prepared for Southern
New England Telephone Co., submitted in CC Docket No. 83-788 by the State of
Connecticut Department of Public Utility Control (1983).

Christensen, Laurits R., Direct Testimony on Behalf of Michigan Bell Telephone
Campany, Before the Michigan Public Service Cammission, submitted in oc Docket.
No. 83-788 (1983),

Cornell, Nina W., Daniel Kelley and Peter R, Greenhalgh, "Social Objectives
and Campetition in Cammon Carrier Canmunications: Incampatible or
Inseparable?," Federal Communications Commission, Office of Plans and Policy,
Working Paper No. 1 (April 1980).

Data Resources, Inc., "Critique of Service Demand and Cost Models Developed
the Southern New England Telephone Company," submitted in CC Docket No. 83-788
by the State of Connecticut Department of Public Utility Control (1983),

Davis, B.E., G.J. Caccappolo and M.A, Chaudry, "An Econometric Planning Model
for American Telephone and Telegraph Company," Bell Journal of Economics and
Management Science (Spring 1973),



-1l-

uninternalized consumption externalities are a serious regulatory concern, a
policy of enccouraging measured-service offerings may be one appropriate way
to respond. 13/ Low-cost service options can help poor people by expanding
the options available to them. Forced bundling of dial tone with unlimited
local calling raises the cost of telephone service for many consumers.

The “merit good" rationale for subsidizing telephone service is simply a
different form of the consumption externality hypothesis and, as such, is
subject to all of the aforementioned criticisms, most importantly the
externality argument's vacuity as a genuine guide to policymaking. 14/ In
this case the posited source of external benefits is not the ability to call
subscribers who without a subsidy would not be available for calling; it is
rather the utility allegedly derived by others simply fran knowing that
subsidized subscribers are hooked up to the telephone system.

The case for assigning merit-good status to telephone service is weak.
For a merit good like school lunches, an in-kind transfer (lunch versus lunch
money) can be justified on the grounds that external benefits to the
population at large derive fran improved nutrition among young people rather
than greater monetary incane which might be spent on junk food. For the adult
poor, it is by no means clear that external benefits associated with incame
redistribution are, in general, tied closely to consumption of particular

goods. While there is a strong case for helping the poor, there is little

13/ A number of consumer groups, as well as some goverrmental officials, have
expressed opposition even to having local measured service as an option.

14/ Richard Musgrave (1959, p. 13) describes merit wants as involving goods
“so meritorious that their satisfaction is provided for through the public
budget [this would include regulatory reassigrments of costs], over and above
what is provided for through the market and paid for by private buyers|[...]
The satisfaction of merit wants, by its very nature, involves interference
with consumer preferences." (Musgrave, 1959)


-13-

comparatively little. 16/ This process of abstraction necessarily involves
exclusion of what may be critical influences for particular individuals. The
focus is instead on general influences that affect most consumers and
predictions are, for this reason, forecasts about average effects. 17/

Econamic analyses of telephone demand treat telephone service like any
other scarce good. Demand is hypothesized to depend upon the price of
service, the prices of complementary goods, the prices of substitute goods,
personal incane, individual tastes and preferences and so on. Changes over
time in virtually all these factors have tended to increase the fraction of
consumers who subscribe to telephone service. In real terms, the prices of
telephone service and its complements have been falling, the prices of
substitutes for telephone service have been rising, personal incomes and the
value of time have been rising and demographic changes (e.g., overall aging of
the population, an increase in the number of single-head households, etc.)
have been working to increase demand for access to the telephone network.

In evaluating the effect of price changes stemming from changes in
regulatory policy, the idea that telephone demand is determined by many
factors needs to be kept firmly in mind. To make accurate predictions of
future demand requires that one simultaneously project the values of all
relevant, demand-influencing variables not just the price of access, into the
future. Failure to do so involves the implicit assumption that the values of
other relevant variables are not going to change in the future. While that is

logically possible, it is extremely unlikely.

16/ See Milton Friedman (1971).

17/ This does not imply that effects on non-average individuals are
‘important. However, it may be the case that their special circumstances
need to be addressed specifically -- that is, more narrowly targeted -- in any
policy response to their problems.


Are Recent FCC Telephone Rate Refoms a

Threat to Universal Service? */

by

Kenneth Gordon and John Haring **/

*/ This paper was originally prepared for presentation at the Fifteenth
Annual Conference of the Institute of Public Utilities in Williamsburg,
Virginia on December 14, 1983, but has since been revised to take account of
comments and more recent research. The views expressed are those of the
authors and are not meant, nor should they be construed to reflect those of
the Federal Communications Commission or any other member of its staff.

**/ Office of Plans and Policy, Federal Communications Commission,
Washington, D.C. 20554.


-34-

D. The Question of Subsidies

The facts strongly suggest that access charges will on average have a
very small effect on telephone penetration rates, Obviously no one is an
average individual or lives in the average place. Costs of Providing access
tend to be higher in rural as compared with urban areas. 52/ Same have sought
to use these cost differences to justify a policy of geographic cross-
Subsidization and the FCC itself proposes a fund to subsidize high-cost
areas. Cost differences provide an exceedingly weak basis on which to justify
subsidies. There are innumerable "cost" differences between urban and rural
areas. To focus on one good and to argue that a subsidy is justified because
that particular good is more costly in one area than another is extremely
myopic. ‘The air tends to be cleaner in the country. Does that mean that
citizens of rural states should be campelled to subsidize New Jerseyans
because of the high cost of clean air in the Garden State?

The FCC has proposed creation of a universal service fund to reduce
geographic cost disparities, but as with any proposal for a subsidy there are
some adverse side effects which are hard to avoid. First, the fund is to be
raised by a surcharge on long-distance service, the same way the current
subsidy is raised. It is thus subject to all the criticisms of the current
system, albeit on a smaller scale. Second, the FCC proposal would target aid
to high-cost areas. Necessarily, this will lead to perverse incentive effects
for econanic efficiency. Although it may well be the case that same of the
higher costs of rural telephone companies are due to irremediable geographic

factors, targeting aid to high-cost areas discourages cost control, whether

52/ This is not always the case. For example, in urban areas where new
conduit is required, costs can be very high indeed.


-22-

depreciation schedules, overextensive cost-averaging or similar distortions
will not be sustainable as canpetition spreads. ‘The history of the opening of
interexchange markets to competition has been told before and need not be
repeated here. We simply noté that, although it was changes in FCC policy
that initially opened the market to campetition, 31/ in more recent periods it
has been canpetition that has driven the actions the Commission has taken. In
particular, the advent of interexchange competition has rendered the
historical method for recovering NTS costs unworkable and necessitated
creation of an alternative method to cover these costs.

Another important change is the FCC's decision to preempt state control
over depreciation for intrastate ratemaking and prescribe more rapid rates of
depreciation for telephone plant and equipment. 32/ The time horizon implicit
in the arguments of those who criticize more rapid depreciation guidelines
solely on the basis of their impact on price, and hence possibly universal
service, is too short, at least on a forward looking basis. 33/ The selection
of a depreciation period should attempt to minimize costs over an extended
period, not just the current period. While the reasons why regulatory
canmissions prefer to depreciate investments over extended periods are easily
understood fran a political perspective, such policies will hurt consumers if
the useful econanic lives of these investments are shorter -- for whatever

31/ The case usually cited in support of this proposition is the so-called
Above-890 Decision. "In the Matter of Allocation of Frequencies in The Bands
Above 890 Mc.," Report and Order, 27 FCC 359 (July 1959).

32/ Amendment of Part 31 (CC Docket No. 79-105), 89 FCC 2d 1094 (1982),
recon. 92 FCC 2d 864 (1983), review pending sub nan. Virginia State
Corporation v. FCC, No. 83-1136 (4th Cir., filed February 11, 1983).

33/ Telephone canpanies are legally entitled to recover their historical
costs. Whether book costs exceed true economic costs and whether companies
would, in a canpetitive envirorment, be required to write off rather than try
to recover these costs are issues subject to dispute.


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of Plane and 2


-30-

little guys even more. Higher business telecarmunications costs are passed
along to consumers in the form of higher prices for the goods and services
consumers purchase. The notion that costs can somehow be shifted fran
consumers to producers is false. Consumers bear all the costs of telephone
service. The issue is whether costs should be borne by those who cause them
to be incurred (either directly or indirectly) or whether they should be
redistributed so that lower prices for some telephone services and some users
are paid for by higher prices for virtually everything and everyone else.

The ubiquitous deadweight welfare losses inefficient pricing inflicts
upon consumers have been previously described. 46/ Inefficient pricing also
causes productive inefficiency (resource waste). In the telephone industry
“bypass" is the “byword” on this topic. Bypass means nothing more than use of
apparently less costly substitute services to avoid use of the basic regulated
phone system. ‘The concentration of telephone use is very high, with about two
percent of all business customers accounting for 79 percent of telephone
company business revenues. 47/ In these circumstances the actuality of even a
few customers taking a significant fraction of their business elsewhere will
have adverse cost consequences for custaners remaining on the network. The
irony is that much of the presently planned and current bypass would not occur
if long-distance services were priced efficiently. In the name of protecting
consumers, and, purportedly, universal service, the current surcharge/subsidy
scheme constitutes the main threat to consumers and universal service. Unless
draconian measures are taken, large businesses will find cost-effective ways
of satisfying their canmunications needs. - That is good for consumers who
46/ Supra, p. 17.

47/ See M. Tannenbaum (1983). Of course, not all of this traffic is
vulnerable to bypass technologies.


-39-

subsidization were more effectively rationalized. Moreover, as has been
widely remarked, the current systen of subsidies will became increasingly
unsustainable given the spread of competition.

The evidence that is available on the demand for access, coupled with

what we know about the likely magnitude of cost increases, indicates that

threats to universal service are minimal or nonexistent. Should any problems
arise, there are a variety of ways of handling then that are consistent with
the basic thrust of the FCC's pro-campetitive decisions. We conclude that

Proposals to roll back or substantially alter the thrust of the FCC's access
charge plan are ill advised in general and cannot be justified as legitimate

responses to universal service threats in particular,


~25-

significant damage. Note especially that in 1970 telephone penetration
nationwide already exceeded 90 percent. 37/

When price increases of the magnitude estimated by the FCC Staff are
canbined with (upwardly biased) demand elasticity estimates close to zero, the
result is obviously a negligible effect on the overall level of telephone
subscribership. This conclusion is strengthened by recognition that other
factors will be simultaneously operating to increase demand for telephone
service. The elasticity of demand for a product depends on the availability
of substitutes. Demand for a product will be more inelastic the fewer the
substitutes there are for it. As already discussed, the measured inelasticity
of demand for telephone service indicates an absence of close substitutes for
such service. This implies that when prices rise, people will, in fact, have
no good alternative to paying the higher prices. Thus, we conclude concerns
over rising prices per se rather than threats to universal service are what
principally motivate opposition to rate reform.

It is likely that few customers affected by the new policies will drop
off the network, but customers who use long-distance service infrequently even
at the new lower rates will probably face higher bills. If this is a problem,
it is primarily one of income distribution fran light to heavy long distance
users. Fear that unlimited local calling (at subsidized prices) may disappear
is another concern. The availability of lifeline or other "barebones"
services specifically designed to protect universality does not really assuage
these concerns. The issues here are essentially distributional in nature and
have only a very little to do with possible threats to universal telephone

service in the United States.

37/ We wish to be clear about the point we are making here. It is that the
price increases contemplated in the access charge and other orders do not
threaten universal service, not that telephone (or any other specific
canmodity) prices should track the general movements of prices.


-y-

that the private benefit of having access to the telephone network exceeds the
actual cost of access. When private benefits exceed costs, individuals will

voluntarily subscribe and simultaneously generate external benefits (perhaps

minimal) for other subscribers in the form of a more valuable network. In
this situation there may be external effects, but they are not relevant for
policy because other determinants of subscribership lead them to be
internalized without the need for subsidies or other forms of government
intervention.

In addition to this (presumably widespread) automatic internalization,
there are other forces operating to internalize external effects. Robert
Preece (1983) points out that few callers ever talk to more than a small
percentage of telephone subscribers and that calls generally go to friends,
relatives and business associates. He argues that people, in effect, fom
"clubs" where those with an interest in mutual accessibility voluntarily agree
to join the same network. In the same vein, subscribers for whan maintenance
of family ties is especially important can pay to have telephones installed
for their relatives, just as they can share the costs of calling. Businessmen
whose own calling requirements may warrant only a single line have a profit
incentive to acquire additional lines so that potential custamers can call
them. In these cases external effects will be internalized because sufficient
benefits accrue to particular individuals to make internalization worthwhile.

The existence of external benefits cannot be used to justify subsidies
unless actual methods of subsidization are specified and their costs

evaluated. On the one hand, when opportunities for strategic behavior 9/ are

9/ Strategic behavior occurs when individuals or firms respond to a subsidy
by incurring unnecessary costs and engaging in otherwise wasteful activities
simply in order to take advantage of the subsidy. In particular, it could
mean shifting costs into the subsidized cost category.


-12-

basis other than paternalism for arguing that help should necessarily take the
form of below-cost telephone access. 15/

But even if a political judgment is made that help for the poor should
take the form of subsidized telephone access, that would still not justify a
blanket subsidy. It may be that one of the "goods and services" we wish
collectively to consume is consumption of telephone service by poor people,
but presumably we also collectively prefer that this be done in a manner that
minimizes the effective cost to society. If we really want to help the poor,
we should do so efficiently, so we can help them even more. It is well worth
noting that there is currently no evidence that either past or proposed
assistance programs for telephone service are either targeted toward deserving
groups or formulated in such a way as to minimize the costs of subsidizing

telephone service for the poor.

III. Determinants of Demand for Telephone Access

A. ‘Theoretical Franework

To gauge the effects of changes in regulatory policy on consumer demand
for access to the telephone network requires an economic model or theory
describing the important factors that affect consumers' decisions to subscribe
to service. As with any scientific model, a good economic model does not
attempt to duplicate reality, an impossible task in any event. The goal is to

abstract fram reality in such a way that much may be explained by

15/ It is a cammonplace in econamic theory that transfers of cash are more
efficient than transfers in kind. See, for example, J. Hirshleifer, (1980,
pp. 118-122).