COMPETITION POLICY IN THE POST-EQUAL ACCESS MARKET

John Raring

Evan &'werel

February 11, 1987

Office of Plans and Policy

Federal Communications Commission

Washington, D. C. 20554

This paper was originally prepared for presentation to the Institute of

Public Utilities' Annual Conference at Williamsburg, Virginia (December 8,

1986). The view s eKpres sed are those of the authors and do not necessarily

reflect the views of the Federal Communications Commission or any other

organization or individual. We wish to thank Peter Pitsch and Tom Spavins

of the Office of Plans and Policy for helpful comments, and Peyton Wynns and

Jonathan Kraushaar of the Common Carrier Bureau for germane data.
Competition Policy in the Post-Equal Access Market

By John Haring and Evan Kwerel

February 11, 1987

I. Introduction

The two conditions that the United States Department of Justice and

District Court Judge Harold Greene deemed necessary to prevent AT&T from

exercising monopoly power and that were embodied in the Modified Final

Judgment (MFJ) in United States vs. AT&T have now been substantially

achieved. First, AT&T has been divested of the Bell Operating Companies

(BOCs). It thus no longer has the opportunity to provide discriminatory

interconnection to competitors, or the ability to subsidize the prices of

its interexchange services with revenue from local exchange services or to

shift costs from competitive interexchange services to local exchange

services. Second, the BOCs are offering their customers equal access to all

long-distance companies to the extent required by the MFJ.l As Judge Greene

noted, " •••with the removal of these barriers to competition, AT&T should be

unable to engage in monopoly pricing in any market."2

1 Under terms of the Modified Final Judgment, most telephone customers

in metropolitan areas (i.e., most customers) now receive equal access to all

long-distance companies. Customers in more rural areas will 'receive equal

access as the necessary equipment is installed in the future. See Section

III for additional discussion of equal access.

2 United States vs. AT&T 552 F. Supp. (D.D.C. 1982) at 172. In

addition, note that AT&T's control of local bottleneck facilities was the

(sole) reason the FCC itself cited for classifying AT&T as a dominant

carrier in its Competitive Carrier proceeding.
We believe that achievement of the relief sought by the government in

United States vs. AT&T provides a logical and compelling basis for now

undertaking revisions in the way in which the FCC regulates AT&T. Indeed,

if now is not the time for change, it is not clear when will be. There are

no other obvious trigger points to motivate revisions in the Commission's

regulation of AT&T.3

There are two basic reasons for undertaking change now and they relate

to the two basic functions regulation performs. Regulation is, in the first

instance, a substitute for competition. Ideally, properly functioning

regulations bring about the results that properly functioning markets would

if competition were feasible. It follows that as market imperfections are

removed (as they have been) and competitive forces play an increasingly

predominant role (as they do), the need for regulation as a substitute for

3 Some of AT&T's competitors have suggested that AT&T cannot be

deregulated until its market share falls to some prescribed level. That

suggestion is transparently self-serving. As Professors Kaserman and Mayo

have noted, "If changes in public policy must wait for the accs to announce

that they are ready to compete openly without regulatory favoritism, then

the current system will undoubtedly endure for a very long time indeed."

See "Market Based Regulation of a Quasi-Monopoly--A Transition Policy for

Telecommunications," Policy Studies Journal (Forthcoming); see also Kaserman

and Mayo, "The Ghosts of Deregulated Telecommunications: An Essay by

Exorcists," Journal of Policy Analysis and Management, Vol. 6 (Fall, 1986).

The reader should note that we are advocating revisions rather than removal

of regulatory controls at this time.

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competition is diminished.4 Maintaining unnecessary regulation would

clearly be wasteful in that it would involve incurring unnecessary costs

and, what is even more important, could actually stifle desirable

competition that would bring benefits to consumers. Note also that

traditional rate-of-return regulation is likely to become increasingly

ineffective and unworkable as competitive forces operate because the

regulated firm's profit rate is increasingly beyond its control. The

post-divestiture AT&T enterprise is no longer a very capital-intensive

business and, consequently, relatively small shifts in its income cause

relatively large shifts in its profit rate.

Regulatory policies may also serve as a complement to competition. For

example, policies providing for equal access and for toll deloading promote

competition by, respectively, lowering entry barriers and expanding the

extent of the market and hence the room for competitors. But while good

regulation can help the competitive process to function effectively,

regulatory failures clearly can prevent it from working. These failures may

involve errors of omission as well as commission. Important in this regard

are questions related to the long-run viability of competition in the

4 This is not to suggest that competltlon has become fully or adequately

effective. On the other hand, competition has certainly become

effective in recent years than it was before. And if the current level of

competition were sustainable over the long run (an open question in our

view), this market would be just as effectively competitive as several other

unregulated markets in the economy.

- 3 -
interexchange business. In its submission to the FCC's Docket 83-1147

investigation of long-run deregulation of AT&T, the Ad Hoc Telecommunications

Users Committee, a group of very large telecommunications users, argues that

"such competition for AT&T's intercity transmission services as has developed

up to now has been primarily driven not by any real economic foundation, but

by entirely pecuniary distortions, principal among which are discounted access

charges and rate averaging. "5 While we believe there are reasons to be

somewhat skeptical of this claim, ultimately the only way to prove or disprove

it is a fair market test. The relief sought by the government in United

States vs. AT&T, approved by Judge Greene, and now substantially effected was

intended to destroy artificial impediments to competition. It would be

unfortunate if the FCC were now to allow its regulations and processes to

operate or be exploited in ways that are fundamentally inconsistent with

competitive market processes. One way to avoid this outcome would be to adopt

policies that are less susceptible to error or abuse than current ones.

This paper is organized in the following manner: Section II

describes in qualitative terms the avoidable costs of current regulation,

that is, costs that need not be incurred to protect consumers from monopoly

abuse. Section III provides a thumbnail sketch of the current state of

5 In a frequently cited academic journal article, MacAvoy and

draw the same conclusion. See "Losing by Judicial Policymaking:

Year of the AT&T Divestiture," Yale Journal on Regulation, Volume

Number 2, 1985.

- 4 -

Robinson

the First

2,
competition in the interexchange market including an evaluation of the

extent of AT&T's market power. Section IV outlines a proposal for revision

of the Commission's regulation of AT&T that we believe protects consumers

who lack competitive alternatives at the present time and obviates concerns

about predatory pricing or cross-subsidization. Section V is a brief

summary •

II. Avoidable Costs of Regulation

The direct costs associated with the FCC's current regulation of AT&T

are not insubstantial. One study submitted in the FCC's Docket 83-1147

deregulation inquiry estimated that direct costs, excluding AT&T's costs,

were more than $40 million per year and that annual savings of between $15

and $25 million were possib1e. 6 In addition to these direct costs, it LS

also necessary to reckon the opportunity costs of the resources expended

under current regulation to gauge the full extent of the regulatory cost

burden. Opportunity costs measure the value of what could have been

6 See Hu1 tina tional Business Services, Inc ./Peat Harwick, "Cost Analysis

of Telecommunications Regulation." The figure for total direct costs was

computed from the combined estimated costs of the FCC and all intervenors

except AT&T. Intervenors included competitors in the telecommunications

industry, industry users, state and local governments and others. While

this study's estimates of potential cost savings are premised on reforms

that differ from those we recommend, we nevertheless believe that they

provide a reasonable ballpark estimate. Indeed, because AT&T's potential

cost savings are excluded, because estimates are based on direct rather than

relevant opportunity costs, and because our suggested revisions are likely

to generate even greater cost savings, this study's range of estimates

should, in our opinion, be viewed as lowerbounds for actual cost savings

likely to be experienced.

- 5 -
produced with given resources in their most valuable alternative employment.

In other words, they represent the value of what we sacrifice by using

resources one way rather than another.

Given the existence of less resource intensive methods of effectively

regulating AT&T, the opportunity costs of failure to adopt such methods

consist of the benefits wasted resources could have produced in alternative

employments. The true economic costs of technically inefficient regulation

of AT&T include, inter alia, the benefits society necessarily foregoes from

less effective regulation of access tariffs, accounting separations and

other important activities of the Commission. As a result of the Bell

System divestiture, the FCC now not only regulates AT&T, but also regulates

the access tariffs filed by the Bell and other telephone operating company

monopolies. The latter constitutes a monumental undertaking involving a

very substantial commitment of resources that, prior to divestiture, was

unnecessary.7 Also in its Computer III Rulemaking the FCC now contemplates

substitution of accounting controls for separate subsidiary requirements to

regulate supply of enhanced information services by the telephone operating

company monopolies. To be effective, accounting controls will also require

7 The theory of the government's relief in United States vs. AT&T was to

separate the competitive elements of the telephone system from the monopoly

ones. The monopoly elements are located in local exchange operations, which

continue to be regulated. But there has been no deregulation of the

presumptively competitive long-distance sector, despite divestiture and

equal access.

- 6 -
a very substantial commitment of resources to evaluate and monitor

compliance with accounting separations plans. Finally, note that at a time

when the Commission's resource requirements are growing, its budget is

shrinking in real terms, and is likely to continue to do so for the

foreseeable future. The upshot is that the opportunity costs of the

Commission's increasingly scarce resources are very high indeed.

To maximize the benefits society derives from its existence, the FCC

should allocate its scarce resources so that, at the margin, the net payoff

to an additional expenditure on any given activity is equalized. The effect

of divestiture, equal access and greater competition in long-distance

communications is to reduce the societal payoff to regulation in this sector

relative to others. Rational resource management in this circumstance

requires reallocation of resources away from that activity where regulatory

productivity has fallen relatively and towards those activities where

productivity has risen relatively.

In addition to the direct and opportunity costs of the resources

involved in administering current regulations, it is also necessary to

consider the economic losses that those regulations impose on consumers.

Regulation may be conceived as the cure for some problems, but it is,

incontrovertibly, the cause of others. That society benefits on net is

certainly disputable. In our view, the principal effect of current

regulation of AT&T is creation of equities in the status guo, regulation

merely serving to isolate firms from competitive market pressures.

- 7 -
We focus on three important adverse consequences of current regulation.

The first is that rate-of-return regulation significantly weakens the

economic incentive for a regulated firm to minimize costs and to maximize

the benefits it provides the public. Inflated costs may take many forms --

plush offices, overdesigned equipment, high salaries, or a bloated

work force. Economists have focused most of their attention on one

distortion, namely, overcapitalization. If regulators set the allowed

rate-of-return above the cost of capital, but keep prices below the

profit-maximizing level, a regulated firm will have an incentive to expand

its rate base beyond the cost-minimizing level. 8 Regulators have attempted

to deal with this adverse side-effect of rate-of-return regulation by

requiring regulated firms to gain approval for investment in new facilities.

In practice such requirements have not been very successful. The FCC has,

for example, approved all of AT&T's requests for new international cables

8 See H. Averch and L. Johnson, "Behavior of the Firm under Regulatory

Constraint," American Economic Review, Volume LII, (December 1962). In his

treatise on industrial organization, F. M. Scherer offers some anecdotal

evidence suggesting that overcapitalizaton was, at a least historically, a

serious problem in telephony. See Industrial Market Structure and Economic

Performance (1970), pp. 533-537.

- 8 -
facilities even when there was little demonstrated need for additional

capacity.9

Even more difficult than preventing inflated costs is assuring that a

regulated firm effectively serve its customers' needs. Assuring that prices

reflect costs and that costs are minimized are fine goals) but they are not

enough if the products and services consumers desire are not produced. In

this respect) AT&T's performance in the customer premise equipment market

was certainly never anything to write home about and) in general) inferior

to the performance of that business segment under competitive organization.

A particularly troubling aspect of this general problem of incentives

is the lack of incentive a rate-of-return-regulated firm has to introduce

product and service innovations. Because the regulated firm's profits are

restricted) its incentives to seek out lower-cost methods of production or

innovative services are also restricted. From society's point of view)

there is nothing wrong with profits ~~. It is ill-gotten profits that

society dislikes and, with justification, seeks to discourage. 10 The

trouble with rate-of-return regulation is that it does not distinguish

9 See E. Kwere1 and J. McNally, "Promoting Competition Between

International Telecommunication Cables and Satellites," OPP Working Paper

Series, No. 18, Federal Communications Commission (January 1986).

10 If monopolizing behavior were legal, that would encourage wasteful

resource investments in acquiring monopoly power.

- 9 -
between profits that are generated by monopoly pricing behavior and profits

that are generated by socially desirable innovative activity. It throws the

baby out with the bath water.

The second adverse effect of current regulation is to divert resources

away from marketplace competition to competition within the regulatory and

political arenas and, thereby, to stifle the competitive rivalry that most

benefits consumers. To reduce rates or introduce new services, AT&T must

first convince regulators that its proposed changes are cost-justified.

That task is formidable enough in the presence of common costs and

uneconomic regulatory cost standards,11 but when its competitors are

permitted (and thus given additional incentives) to delay and harass AT&T,

passive, noncompetitive behavior on AT&T's part is encouraged. Vigorous

competition is thereby discouraged and consumers' expectations are likely to

be frustrated. In this regard, note that AT&T's competitors have opposed

virtually every price reduction proposed by AT&T in the period since

divestiture and have in many cases successfully delayed the availability of

beneficial price cuts to consumers. No one concerned with the economic

11 In unregulated markets prices are determined by supply and demand, and

increases in supply relative to demand may cause prices to fall below

individual firms' book costs. That leads naturally to equilbrating

reductions in supply. Regulatory attempts to prevent prices from falling

below (mismeasures of) costs may lead to further increases in supply and

eventually to even greater downward pressure on prices. They are thus

likely to be wasteful and self-defeating.

- 10 -
welfare of consumers can logically argue that toll rates should be kept

artificially high and that the FCC should practice handicapped regulation and

umbrella pricing in toll markets.

A third important adverse consequence of current regulation is that it

prevents the Commission from acquiring the information it needs to make a

reasoned determination about the long-term viability of competition in the

long-distance business. Current regulation makes it impossible to

distinguish whether the market entry we observe reflects actual comparative

efficiencies on the part of competing firms or is merely a response to

distortions introduced by regulation itself and hence not sustainable as the

distortions are mitigated by competition. Without knowing the genealogy of

observed entry, it is impossible to prescribe, with any acceptable degree of

confidence, long-term regulatory policies that will promote consumer

welfare. 12 How can the Commission presume to act in the public interest when

it lacks the information it needs to make reasoned policy determinations?13

12 See J. Haring, "Implications of Asymmetric Regulation for Competition

Policy Analysis," opp Working Paper Series, No. 14, Federal Communications

Commission (December 1984).

13 Besides being incompatible with the use of compet1t10n as a discovery

procedure, continued rate-or-return regulation may also be incompatible with

the natural evolution of a competitive market structure. For example, if

there is regulatory failure and AT&T is not permitted to earn a competitive

rate-of-return, that will effectively exclude all rivals who are not

efficient than AT&T. And that problem will be exascerbated if new entrants

must pay a premium for capital because their capacity to produce profits is

unproven and, therefore, possibly riskier.

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III. The Extent of AT&T's Market Power

In this section we examine the extent of AT&T~s market power. Market

power is the ability of a firm to maintain prices profitably above minimum

costs of production for an extended period of time. We assume that the

purpose of regulating AT&T is to limit the exercise of market power. It

follows that to the extent AT&T's market power is being dissipated the

putative benefits of regulation are declining.

While one can't be a little pregnant, a firm can have a little market

power. Indeed, most firms in the economy possess some market power.

Showing that a firm possesses market power is not sufficient to justify

regulation. Instead, the relevant question is at what level of market power

do the benefits of regulation outweigh the costs. We believe that AT&T's

ability to raise prices above competitive levels has fallen to a point where

the benefits of rate-of-return regulation fall short of its costs.

Presently, we will propose a streamlined form of regulation to limit AT&T's

ability to exercise whatever market power it may still possess.

A. Analytical Framework

A firm's ability to raise prices profitably above the perfectly

competitive level depends on the degree to which it loses customers as it

raises its price. The more customers it loses, the less its price will

deviate from the competitive level. In technical economic terms, a firm's

market power may thus be said to vary inversely with its perceived

- 12 -
elasticity of demand, the latter defined as the percentage loss in quantity

sold when price is raised by one percent.14

When one firm in the market acts as a price setter while the remaining

firms act as price takers, the elasticity of demand (ed) facing the pricesetting firm can be expressed in terms of the market elasticity of demand

(Ed), the elasticity of supply of the other firms in the market (Es ), and

the price-setting firm's market share (s). It can be shown that:15

(1)

We consider each of these three factors as they apply to AT&T.

Market elasticity of demand: One constraint on AT&T's market power is

the market elasticity of demand. If the price of long-distance services were

to rise, customers would reduce their total consumption of such services. They

would economize on their calling and substitute postal services, personal

visits and other alternatives for telephone communication. Some calling might

be foregone altogether, and other calls will be of shorter duration. From

equation (1) it is clear that the greater the market elasticity of demand (Ed),

14 William Landes and Richard Posner, "Market Power in Antitrust Cases,"

Harvard Law Review, 94:5 (March 1981).

15 See Landes and Posner, p. 945.

- 13 -
the greater the elasticity of demand faced by AT&T, other factors the same.

Econometric studies suggest that the market elasticity of demand for

long-dis tance services is on the order of .5 in the short run and approximately

unitary elastic in the long run after consumers have had a chance to adjust

their consumption. 16 These elasticities imply that if AT&T were to raise price,

its revenue would increase in the short run and remain roughly constant in the

long run, assuming the absence of rival firms. Since its total costs would

fall or remain constant as output declined, its total profit would rise.

Supply elasticity of competitive fringe: Another constraint on AT&T's

willingness to raise its prices is its fear of losing customers to its rivals.

In terms of equation (1), the larger the elasticity of supply (Es) of the

competitive fringe, the larger the elasticity of demand perceived by AT&T. If

AT&T's competitors increased their output by a large amount in response to a

price increase, AT&T would lose a large percentage of its sales to other firms

by raising price.

One indication of large elasticity of supply in the long-distance

business is the rate and relative ease with which productive capacity is

currently being expanded. A survey by The Hudson Institute indicates that

firms other than AT&T plan to add more than 5.3 billion circuit-miles of

16 Lester Taylor, Telecommunications Demand: A Summary and Critique,

(Cambridge, Massachusetts: Ballinger Publishing Co., 1980), p. 100.

- 14 -
fiber-optic capacity to the U. S. long-distance telephone network by 1988.

This would represent a 379 percent increase over the approximately 1.4

billion circuit-miles of total u.s. capacity in 1985.17

According to a recent survey conducted by the the Industry Analysis

Div ision of the FCC's Common Carrier Bureau (CCB), carriers other than AT&T

have already put in place large amounts of fiber-optic transmission

capacity.18 The CCB es timates that about 650,000 fiber-miles of capacity

was installed by the end of 1986 by carriers other than AT&T. (See Table

I). That capacity could prov ide approximately 1.6 billion 2-way circuit

miles using current optical electronics technology and over 4 billion

circuit miles using terminal and repeater technologies likely to be

available in the near future. The presence of such large amounts of easily

expandable capacity clearly constrains AT&T's ability to exercise market

power by restricting output. Note also that once capacity is installed, it

is effec tively sunk and cannot exit. That means that while the identities

of future competitors may differ from those of current competitors, there

will, in fact, be supply alternatives in the future. Huge increases in

supply relative to demand spell lower and lower prices well into the future.

17 William Johnston, "The Coming Glut of Phone Lines," Fortune,

(January 7,1985).

18 Jonathan Kraushaar, "Fiber Deployment as of Yearend 1986," Industry

Analysis Division, Common Carrier Bureau, FCC (December 1986).

- 15 -
Table I

Estimated Fiber Deployment by Major Interexchange Carriers

Yearend 1986

Fiber-Miles Percentage

AT&T 261432 29%

U.S.-Sprint 172469 19%

MCI 167400 18%

Lightnet 158785 17%

NTN 133182 15%

Electra 10194 1%

RCI 6960 1%

Total 910422

Source: Jonathan Kraushaar, "Fiber Deployment as of Yearend 1986," Industry

Analysis Division, Common Carrier Bureau, FCC (December 1986).

- 16 -
Market share: Market share is another factor to be considered in

analyzing market power. Holding constant the market elasticity of demand

and the elasticity of supply of competitors, equation (1) indicates that the

larger a firm's market share the smaller its elasticity of demand, and,

hence, the greater its market power. Of course, equation (1) also shows

that market share is only one factor affecting market power. Even if market

share were large, market power would be small if the market elasticity of

demand or the elasticity of supply of competitors were large.

The influence of market share can be decomposed into its interaction

with the market elasticity of demand and with the elasticity of supply of

competitors. To simplify the exposition, we will assume that the elasticity

of supply is zero when discussing the market elasticity of demand and vice

~. First, consider the influence of market share on the relationship

between the market elasticity of demand and the elasticity of demand facing

the firm. The smaller the market share of the price-setting firm, the

greater the percentage reduction in its output for a given percentage

reduction in market output, and hence the greater its elasticity of demand

relative to the market elasticity of demand. For example, if the market

output is 100 units while the firm's output is 10 units, a 5 unit reduction

in output would represent a 5% reduction in market output but a 50%

reduction in the individual firm's output.

Similarly, as the firm's market share falls (and the share of the

competitive fringe increases), a given percentage increase in supply by the

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competitive fringe will represent a larger percentage increase relative to

market output, and a larger percentage decrease in the sales of the pricesetting firm. This means that the price-setting firm must reduce its output

by a greater percentage to achieve a given percentage increase in market

price, the smaller its market share, given the elasticity of supply of the

competitive fringe and the market elasticity of demand.

AT&T's share of the long-distance business has been steadily declining.

Table II shows that AT&T's share of the interstate toll market has dropped

significantly during the last two years. AT&T's share of total minutes fell

from about 83% to 77%. In those particular market segments where the OCCs

have chosen to compete, AT&T's market share has fallen to significantly

lower levels. One study estimated that AT&T's share of the business in

"contested" market segments fell below 70% in 1986 and would be less than

60% by 1988.19

These figures overstate AT&T's prospective market power because they

reflect historical sales, rather than the ability to compete for customers

in the future. Thus AT&T's share of productive capacity may be a better

measure of its market power. AT&T's capacity share is falling quite

19 See Multinational Business Services, Inc., "Competition in the

Telecommunications Marketplace," October 1986.

- 18 -
precipitously. Table I shows that as of yearend 1986, AT&T controlled only

29% of fibe r opt ic in t erexchange capacity. Even when conventional capacity

is included in the calculation of capacity share, AT&T's share falls well

below 50%.

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Table II

AT&T's Share of

Interstate Switched Access Minutes

1985 : Quarter 1 83 .1%

Quarter 2 80 .3%

Quarter 3 78.5%

Quarter 4 77.2%

1986 : Quarter 1 78.9%

Quarter 2 77.9%

Quarter 3 77 .0% (prel iminary)

Source: Data on AT&T's access minutes are contained in a letter from D.

Culkin of AT&T to A. Halprin, Chief, Common Carrier Bureau, FCC, November

24, 1986. Data on total market access minutes are from National Exchange

Carrier Association (NECA), "Monthly Summary of Pool Results," monthly

reports filed with the FCC.

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B. Addit iona I Considerations

For purposes of analyzing market power, certain other considerations

may be usefully taken into account. These include the geographic location

of call origination and destination, type of service, and customer size:

'p'~Destination--InternationalCalls: The market power analysis

given above is not applicable to the international market. The most

significant difference between the international telecommunications market

and the domestic market is that foreign telecommunication authorities

(PTT's) control access to foreign markets but are not subject to U.S.

regulation. In such an environment, market power possessed by U.S.

international carriers could, in fact, serve U.S. interests by

coun t erba lane ing the market power of PTT's. Rate-of-return regulation does

not protect the interests of U.S. consumers of international

telecommunications, in any event, because it permits regulated U.S. carriers

to pass on the costs of payments to monopoly PTT's.20

]:xchange in which Call Originates--Egual Acc~ss. Pr~sence of

Competitors: The degree of AT&T's market power for interstate switched

voice service (MTS) may vary across local exchanges depending on the

presence or absence of competitors offering such service in a particular

exchange, and on the availability of equal access. As part of the

20 See Kwerel and McNally, pp. 61-64.

- 21 -
divestiture agreement between AT&T and the Department of Justice, the BOCs

are required to offer all long-distance carriers access that is "equal in

type and quality" to that provided to AT&T. Likewise, the GTE Consent

Decree requires the eighteen GTE telephone operating companies to provide

equal-access interconnection. Equal access assures all long-distance

carriers equal transmission quality, permits all carriers to offer service

to customers with rotary as well as tone phones, allows customers to reach

all carriers by dialing the same number of digits, allows all carriers to

automatically identify the phone number of the party originating a calIon

its network, and allows all carriers to determine precisely when a call has

been terminated. Under the divestiture agreement, each BOC was required to

offer equal access in offices serving at least one-third of its lines by

September 1, 1985, and to offer it in the remaining end offices by

September 1,1986 "upon bona fide request."

By the end of 1986 about 70% of all lines were converted to equal

access. 21 Of course, many people without equal access still have a choice

of two or more carriers, albeit in a less convenient but also less expensive

form. Assuming that all of the people with equal access have a choice of

carrier but that only half of the customers without equal access have such a

21 Bell Operating Companies, with about 80% of all lines, converted 74%

of their lines, while independent companies converted 38.6%. "Trends in

Telephone Service," Industry Analysis Division, Common Carrier Bureau, FCC,

February 2, 1987.

- 22 -
choice, about 85% of all customers will have a choice of two or more

carriers by the end of 1986.22

While AT&T's market power may be greater in those exchanges currently

lacking actual competitors, its market power is still, of course, limited by

the ability of competitors to enter these markets. Expansion of an existing

network into new territory is easily accomplished. Moreover, it is

certainly possible that AT&T's market power may actually be less in markets

without equal access than in those with it. This is merely a reflection of

the generous 55% discount on access charges OCCs receive for non-premium

service. That discount more than compensates these carriers for lower

quality interconnection. Thus OCCs are more likely to be able to undercut

AT&T's prices and expand output at AT&T's expense in exchanges without equal

access, other things being equal.

Type of Service--Switched vs. Private Line: One would expect the

private-line market to be more competitive than the switched-services market

because private-line users are highly sophisticated and have enough at stake

financially to justify shopping carefully for the best deal. Indeed, the

private-line market was the first service to experience competitive entry.

On the other hand, the fact that few carriers currently offer private-line

22 This estimate does not take into account the fact that some customers

have multiple lines.

- 23 -
services relative to the number offering switched services suggests that the

private-line market may be less competitive than the market for switched

services. The lack of suppliers may, however, be result of regulation,

and not an indication of the potential long-run competitiveness of the

private-line market. There may be few firms offering private lines because

private-line users have been effective in using the regulatory process to

hold down AT&T's private-line prices. Individual private-line users may save

enough from a reduction in private-line rates that it pays them to

participate actively in the regulatory process. The fact that AT&T reported

a negative rate of return on private line services of 4% for 1984, at the

same time that it reported positive earnings of 15% on switched services is

strong evidence that regulation has held private-line rates below the

competitive level. 23 Absent regulation, AT&T would have the freedom to

raise its prices for private lines, but if it did new competitors would

quickly enter the market. Moreover, many private-line users are large

enough that they may be able to put together their own system.

Alternatively, large users might sign long-term contracts with AT&T's

competitors, thereby sharing the risk that AT&T might lower its prices.

23 See AT&T Tariff Filing Reference Package, Vol. 2, 1984 Annual Fully

Distributed Cost Report, June 1985.

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Transactions Costs, Product Differentiation and Size of User: The

model discussed in Landes and Posner's article assumes a homogeneous

product, perfect information about prices, and no transactions costs

involved in changing suppliers. Under these conditions, if a firm raised

its price above that of other firms, it would lose all its sales. Thus,

there would be a single market price in equilibrium. In their model the

dominant firm raises the market price by reducing its output. This

describes some markets better than others. For example, it may be a

reasonable description of the market for oil in the early 1970's. Saudi

Arabia was a dominant supplier at that time and was able to raise the world

price of oil by reducing its output.

In the telecommunications market, however, individual carriers do not

all charge the same price for a service. One reason for this is that the

products offered by different vendors are not identical. For example,

people appear willing to pay more for more reliable or clearer connections.

Another reason is that it is costly to become fully informed about prices

and service characteristics. It is also costly to calculate whether it pays

to switch to a new carrier. It may not pay small users to incur these

costs, so they may continue to use AT&T even if they might be better off if

they could costlessly switch to some other carrier.

Transactions and information costs may thus give an incumbent firm such

as AT&T a modicum of market power. The profits obtainable from raising

price to these users are limited, of course, by the small volume of calls

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each of these users makes) the modest size of relevant information and

transactions costs) and the ability of competitors to reduce the information

costs by advertising. The more AT&T seeks to extract a premium over cost)

the greater the incentive of its competitors to advertise that fact.

IV. Proposal

We have argued that AT&T's ability to raise prices above competitive

levels is generally constrained by the ability of competitors to expand

their output and the demonstrated willingness of customers to switch to

alternative sources of supply. Yet there may be some areas in which AT&T

retains market power. For example) small users in exchanges currently

served only by AT&T might be one example. Such exchanges are typically in

rural areas served by independent local exchange carriers.

Note) first) that requiring AT&T to maintain a single nationwide price

schedule limits its ability to exercise market power in any particular

geographic region. AT&T cannot raise prices for those customers who

currently have no choice of long-distance carrier without simultaneously

raising the prices for those who do. Uniform nationwide pricing

requirements place less of a constraint) however) on AT&T's ability to raise

prices in the submarket composed of small users. AT&T already serves these

customers and may derive some limited market power from the fact that it may

not pay such customers to incur the information and transactions costs

involved in finding a lower-priced carrier. Even with the requirement that

AT&T maintain uniform national prices) AT&T could conceivably establish a

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set of optional calling plans that allowed it to charge lower prices to

high-volume customers for which AT&T faces intense competition and higher

prices to those small-volume customers for which it faces less intense

competition.

There are several options for dealing with the possibility that AT&T

may retain pockets of market power in a limited number of areas. One is to

continue subjecting AT&T to the current form of regulation in all markets

because some markets may not be competitive. The second is to deregulate

only those markets that are deemed competitive. The third is to deregulate

all markets despite the fact that some may not be competitive in the short

term. Finally, there is the option that we examine here. The essence of

our proposal is to replace rate-of-return regulation with a price cap on a

limited set of "core" services that must be offered in all markets. We

consider each option in turn.

The option of continuing to regulate AT&T in all markets has little to

recommend it. It would be a mistake to forego the benefits of rapid

introduction of new services and innovative pricing schedules in all markets

because AT&T retains some residual market power in certain areas.

The option of market-by-market deregulation would present great

administrative problems. Many of AT&T's facilities simultaneously serve

both regulated and unregulated markets, and there is no meaningful (i.e.,

economically nonarbitrary) way to apportion joint costs to separate markets.

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Thus the FCC might find itself bogged down in endless debates about

cross-subsidies between regulated and unregulated markets.

The third option of complete deregulation appears to be the best

long-run approach. It eliminates the distortions associated with

rate-of-return regulation and gives AT&T the freedom to introduce new

services and pricing options without lengthy regulatory delays. Buts as

noted above s it fails to account for the possibility that AT&T may retain

some market power over small customers in exchanges without equal access and

where rivals are absent and not likely to enter because of the small number

of customers to be contested.

We believe that the fourth option offers the best balance between

preventing AT&T from exploiting any residual market power it possesses and

providing customers with the benefits of more innovative service and

pricing. The essence of this approach is to replace the current system of

rate-of-return regulation with a price ceiling on a small set of core

offerings. Core services would be defined so that for any service over

which AT&T has significant market powers that service would either be within

the core or there would be a close substitute for the service among the

regulated core services. AT&T would be required to offer the core services

at a uniform price throughout the country. These core services might

include MTS and WATS or perhaps only MTS. Private lines probably would not

be classified as a core service because this market is potentially highly

competitive (i.e. s AT&T lacks significant market power).

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The price cap on core services would initially be set at the current

level. A formula would then be established for changes in the cap. For

example) the cap might be indexed to reflect changes in the purchasing power

of money as well as the rate of long-term productivity growth ~n the

telecommunications industry. The cap should also be adjusted to allow for

changes in access charges. AT&T would be free to set the price of services

outside the core offerings anyway it chose subject to continuation of the

current nationwide averaging requirements. It would also be free to offer

any new services without FCC approval.

Setting a price ceiling on a set of core serv~ces would constrain

AT&T's pricing of all services while avoiding the delays (and opportunities

for abuse of regulatory process) inherent in the tariff rev~ew process.

Market forces would prevent AT&T from pricing any of the non-core offerings

above the level of core services at any volume of usage. Users would

compare the cost of AT&T's non-core offerings with the cost of the core

service at their levels of usage) and would only choose the non-core

offering if it was cheaper or had better service characteristics than the

core offering.

The price ceiling would also effectively limit AT&T's ability to engage

in predatory pricing. For predatory pricing to be profitable the predator

must be able to raise its prices once it has driven its competitors from the

market. Only in this way will it be able to recoup the losses it incurred

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during the period of below-cost pricing. But if there is a price ceiling,

AT&T would not be able to raise its prices to reap the benefits of

predation, so it would have no incentive to engage in predation. 24

Finally, the proposal would eliminate the problem of cross-subsidization

between regulated and competitive markets. Cross-subsidization is a problem

caused by regulation. Without rate-of-return regulation AT&T would have no

incentive to engage in cross-subsidization. Cross-subsidization occurs

because regulation limits the profits that may be earned in some activities

but not others. Under rate-of-return regulation a firm has an incentive make

it appear that profits earned in the regulated activities were earned by the

unregulated ones. It may do this either by charging costs of the unregulated

activities to the regulated ones or by crediting revenues earned by the

regulated activities to the unregulated ones. If there is no absolute

regulatory limit on the amount AT&T may earn in any of its activities, AT&T

would have no incentive to do this.

V. Concluding Remarks

We believe we have described a "better way" in this paper. Specifying a

better way is not the same as effecting one, although it might be a step in

that direction. The British have adopted a variant of the approach we have

24 See William Baumol, "Quasi-Permanence of Price Reduction: A Policy

for Prevention of Predatory Pricing," Yale Law Journal, (November 1979).

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outlined.25 The "problem" the British now confront is that British Telecom

has lowered its costs substantially and is earning high profits. These

profits "look bad" even though they represent a freeing-up of resources to

produce other sources of consumer welfare.

One proposal now being considered by the British is to "look at" the

regulated firm's profitability periodically. If profits are judged to be

"too high," then the price ceilings might be lowered. The problem with this

approach is that it might stifle the innovative or economizing activity that

is responsible for lower costs or more effective performance in the first

place. It puts the benefits of such activity at risk. If society merely

substitutes one form of profit regulation for another, it will necessarily

sacrifice much of the benefit of getting rid of profit regulation. There

are no eggs if you kill the goose.

25 See 1. M. Stelzer, "Regulating Telecommunications in Britain: A New

Alternative to the U.S. Approach," Telematics, Vol. 3, No.9 (September

1986) •

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