The small number of competitors implies comparatively low costs of
collusion, but there are strong incentives to cut prices (i.e., to cheat on
any collusive understanding) to increase network utilization and thus to
spread the high fixed costs. Of course, incentives to cut prices will be
mitigated to the extent that asymmetric government tariffing regulations
supply a price umbrella. And effective recognition of mutual
interdependence will be easier to the extent that tariffing and other
regulations make it easier for competitors to signal their own intentions or

to fathom the intentions of their rivals.

On the theory that structure determines performance (i.e., the theory
of industrial organization economics), !2 a comparably unregulated
long-distance business might thus be expected to perform about as well as
the automobile industry in terms of satisfying eonsumers' desires.
Unfortunately, the Communications Act of 1934, as amended, would appear to
preclude a market test of the validity of that prediction. It is also
perhaps worth noting in passing that, in contrast to long-distance, not only
is the automobile industry not subject to price regulation, but it is also,
as a consequence of government import restrictions, actually afforded

significant protection from competition.

12 See F. M. Scherer (1980).

-17-


It matters little, however, upon which measure of relative supply
capability one focuses. By either measure the assumptions of the
dominant-firm model are clearly violated. The "fringe" supply capability is
very large relative to both the size of the market and the inductry's total
capitalization. MCI and U.S. Sprint account for 115 percent of AT&T's
capitalization and 47 percent of the industry's total assets (compared to

AT&T's 40 percent).

The idea that a fringe accounting for 60 percent of total capital and
capable of supplying 146 percent of the market can ignore its effect on
AT&T's pricing decisions strains credulity. Only the government's
willingness to afford the fringe some semblance of a pricing umbrella lends
it any plausibility. The idea that AT&T would voluntarily allow fringe
competitors to sell all that they wish given their ability to serve (more

than) the whole market is, of course, totally ludicrous on its face 8

The evidence adduced here thus suggests that AT&T is no longer a

dominant firm. Claims that it is for the most part merely represent

8 The existence of large amounts of private capacity and the readily
apparent potential for construction of additional private networks further
constrain AT&T's pricing flexibility vis a vis large corporate customers.

-W-


Fearing that a rate-of-return regulated carrier might try to leverage
its its dominant position in other markets to compete unfairly in markets
for which it lacked market power, the Commission tentatively concluded that
cost allocation and nondiscrimination safeguards were essential to its
“piecemeal deregulation" proposal. 19 Note, however, that the absence of
rate-of-return regulation and a lack of market dominance would clearly

mitigate the need for such safeguards.

In the Price Caps docket, the Commission has replaced rate-of-return
regulation with rules that effectively define ceilings or caps on the rates
that AT&T may charge for its regulated services. Under the Commission's
price cap rules, an AT&T filing that proposed to alter rates of an existing
service would be eligible for streamlined tariff review as long as the new

rates did not exceed the applicable rate ceilings.

Under this regulatory regime, the prime focus is on rate levels rather
than profit levels. The ceiling on rate levels and the spread of effective
competition virtually eliminate AT&T's ability to subsidize more competitive
services with revenue from less competitive services. Thus under a price
cap approach, it should be possible to proceed with the sort of regulatory

reform proposed in the Basic Services Deregulation docket without cumbersome

19 Id. at 650.

-21-


Introduction

It has been remarked that regulation is largely a matter of
definitions. Perhaps the most important definitional distincticn currently
drawn in telecommunications regulation is that involving the economic
concept of market dominance. A firm's status as either dominant or
nondominant makes a huge difference in both the number and difficulty of the

regulatory hurdles it must overcome. !

This paper first identifies the confluence of circumstances that
determine whether the dominant-firm model supplies an accurate description
of marketplace reality and, hence, a reliable basis for policymaking. It
then examines whether these conditions currently prevail in the markets for
long-distance telecommunications services in the United States. Our
conclusion is that they do not and, thus, that the dominant /nondominant

dichotomy provides a questionable basis for assessing regulatory burdens.

These conclusions are, of course, ones that AT&T's rivals in the
long-distance business are not likely to share. But their opposition is a
prediction of our analysis, and thus serves to confirm its validity.

Maintenance of an outmoded system of asymmetric regulation stifles

1 The difference in regulatory treatment afforded dominant and
nondominant carriers is described in an appendix.




The conclusion that regulation should be symmetric (i.e., should
attempt to treat likes alike) leaves unresolved the kind of regulation that
should be uniformly imposed upon all regulatees. In our view, the least
desirable regulatory model would be one that imposes upon all incerexchange
carriers the regulatory burdens under which AT&T now labors. Few would
dispute that the costs such a regime would impose upon regulators,
regulatees, and subscribers would vastly outweigh any benefits that might
flow from its imposition. In fact, any form of symmetric regulation short
of forbearance will impose new administrative costs on AT&T's competitors
without any apparent benefits to the public they serve.!3 Indeed, the
public might well be harmed if new regulation actually facilitated

collusion.

From a policy perspective, the most attractive form of symmetric
regulation would be to extend to AT&T the forbearance approach now applied
to its rivals. But a crucial element of the legal argument supporting the
Commission's decision to forbear from regulating AT&T's nondominant

competitors was that AT&T's rates remained subject to direct Commission

13 The FCC has already recognized that "(t]he presence of traditional
regulation itself may be a significant entry barrier to a market that
otherwise could operate efficiently on a highly competitive basis."
Decreased Regulation of Certain Basic Telecommunications Services, 2 FCC
Red 645, 646 (1987) (hereinafter “Basic Services Deregulation Notice").

- 18 -


The Commission's Basic Services Deregulation docket has already laid a
sound policy and legal foundation for adoption of the core/noncore concept.
Grafting this concept onto the price caps structure already in place for
AT&T would produce regulatory reform simpler and still more effective than
would be possible under either docket alone. The synergy between the two
concepts, price caps and core/noncore, could create a regulatory scheme in
which all but a relatively few AT&T services could be automatically eligible
for streamlined tariff review. The tariff filings associated with the
remainder of AT&T's regulated services, the core services, would remain
eligible for such treatment as long as they comply with individual price
ceilings. The end result would be regulation that enhances both the ability
and the incentives of all carriers to respond to consumer demand, an outcome

clearly in the public interest.
Conclusion

Is regulation part of the solution or part of the problem? The
regulatory apparatus that currently governs long-distance telecommunications
is a vestige of historical monopoly and was specifically designed to control
a dominant firm that is, in fact, no longer dominant. Maintenance of that
regime in today's changed circumstances is increasingly likely to produce
noncompetitive results and, thus, to harm consumers rather than to protect

then.

- 2b -


and the Basic Services Deregulation docket.

In the Basie Services Deregulation docket, the Commission proposed to

refine the market analysis presented in its Competitive Carrier Jocket to
recognize that a carrier could be dominant in some basic service markets and
still be nondominant in others. 16 For those service markets in which an
otherwise dominant carrier was found to be nondominant, the Commission
tentatively concluded that the carrier's tariff filings should be eligible
for streamlined tariff review.’7 Packet services and contract services
offered after competitive bidding were explicitly singled out as potentially

qualifying for such treatment. 18

16 Op. cit. at 646-647.

17 Id, at 647. Under streamlining, the Commission would presume the
carrier's tariff filings to be law ful. A petitioner seeking suspension of
such a filing would have to demonstrate that; (a) there existed a high
probability that the tariff would be found unlawful after investigation;
(b) the harm alleged to competition would be more substantial than the
injury to the public arising from the unavailability of the service under
the rates and conditions proposed in the challenged tariff filing; (ec)
irreparable injury would result if the tariff filing were not suspended; and
(d) the suspension would not otherwise be contrary to the public interest.
Tariffs subject to streamlined review could take effect on 14 days notice
(rather than the 45 or 90 days notice required of dominant carriers under
Commission rules) and need not be accompanied by the economic support data
specified in Section 61.38 of the Commission's rules. See id. at n. 8.

18 Id. at 645.

- 20 -




Thinking the Thinkable

From AT&T's lack of dominance, the effectiveness of competition in the
long-distance business does not necessarily follow. First, under a
continuing regime of asymmetric regulation, AT&T's effectiveness as a
competitor may be significantly constrained. That may reduce the market's
ability to police itself through the operation of a competitive process. 10
Second, even in the absence of regulatory asymmetries, effective recognition
of mutual interdependence and coordination of supply decisions among

(nominally) competing firms may lead to noncompetitive results.

The effectiveness of competition rests, in part, on the intensity of
the fear of failure that motivates competitors’ efforts to discover and
satisfy consumer preferences. The greater the fear of business loss, the
greater the degree of consumer sovereignty. Regulations that insulate
competitors from competitive pressure by delaying or preventing the
introduction of new services or the discounting of existing ones thus reduce

consumer sovereignty. Just as consumers are harmed by artificial restraints

10 If one of the runners in a race is artificially handicapped, that may
make the rivalry less intense and the contest less capable of producing a
superior performance.

-15-


artificial entry barriers.6

Recall that the dominant firm optimizes over a residual demand schedule
given by the difference between market demand and anticipated fringe supply.
As fringe supply capabilities expand, that residual demand declines and
becomes more elastic, leading the dominant firm to reduce the price of its
services. This, of course, assumes that regulation has not already reduced
prices and that the firm is permitted to reduce its prices under regulation.
Just as the fringe can be expected to oppose regulation-induced price
reductions, it can be expected to resist competition-induced price
reductions as well. The higher the dominant-firm pricing umbrella, the

greater the opportunities for expansion of fringe sales.

As the supply capability of the fringe rises relative to the size of
the market, the assumptions underlying the dominant-firm model are violated.
At some point, fringe firms can no longer ignore the effects of their
actions on market prices or on the decisions taken by the (formerly)
dominant firm or by other firms. Similarly, as the supply capability of the
fringe rises relative to the size of the market, the dominant firm
eventually can no longer afford simply to allow fringe firms to sell all

they wish at the price it selects.

6 A barrier to entry exists when a firm is barred from competing even
though it can meet all cost and production requirements. Requirements for
effective performance do not constitute economic barriers.


their offering regulated and unregulated telecommunications services on an
integrated basis. Among these nonstructural safeguards are requirements:
that a dominant carrier use a Commission approved cost allocation manual
for apportioning costs between regulated and unregulated services; that it
disclose changes to its network that will affect the ability of competitors
in the market for unregulated communications services, called enhanced
services, to interconnect with that network several months before the
changes will become effective; and that it develop an open network
architecture through which such competitors can have access to the same
facilities and functionalities that the dominant carrier uses to provide
these enhanced services. Again none of these rules apply to nondominant
carriers that choose also to offer enhanced services, of which electronic

mail is but one example.


Appendix: Differences in Regulatory Treatment Afforded Dominant and

Nondominant Carriers

In the course of its Competitive Carrier Rulemaking Docket the
Commission imposed an increasingly asymmetric regulatory regime upon the
common carriers subject to its regulation. See Policy and Rules Concerning
Rates for Competitive Common Carrier Services and Facilities Authorizations

Therefor, CC Docket No. 79-252, First Report and Order, 85 FCC 2d 1

(1980)(specialized common carriers and resellers of terrestrial common
carrier services operating in the contiguous 48 states designated
nondominant henceforth subject to streamlined regulation); Second Report
and Order, 91 FCC 2d 59 (1982) (forbearance from even streamlined regulation
appropriate for terrestrial resellers whenever it furthers the purposes of
the Communications Act), recon. denied, 93 FCC 2d 54 (1983); Third Report
and Order, 48 Fed. Reg. 46971 (Oct. 14, 1983) (specialized common carriers
and resellers of terrestrial common carrier services operating between any
U.S. offshore points or Alaska and the contiguous states now covered by same

regulatory policies as those operating within the contiguous states); Fourth

Report and Order, 95 FCC 2d 554 (1983) (forbearance applicable to all

resellers of domestic common carrier services and specialized common
carriers; domestic satellite carriers, miscellaneous common carriers and
facilities-owning interexchange carriers affiliated with certain of the
independent telephone companies classified as nondominant carriers eligible

for streamlined regulation); Fifth Report and Order, 98 FCC 2d 1191 (1984)


price he likes; the others take that price as a given in deciding how much
to supply, expanding their supply the higher the given price. The price-
searcher takes these supply decisions into account (i.e., he anticipates
the reactions of the fringe to the price he chooses) in deciding what price
he likes. He, of course, prefers a high price, but the higher the price,
the less he sells as consumers substitute other goods and the competing
products of fringe suppliers. So he must balance the gains and losses of a

higher price in deciding what price maximizes his profit.

The dominant-firm model predicts an equilibrium price that is lower
than the case of pure monopoly and higher than would obtain if there were
perfect competition. On the one hand, it shows how a price-searcher is
influenced not only by conditions affecting market demand and his own supply
capabilities, but also by the supply capabilities of competing firms. The
latter reduce and make more elastic (i.e., more responsive to price changes )
the demand the price-searcher confronts. He is thus compelled to charge a
lower price than he would if effective competitive alternatives did not

exist or were only a possibility .4

4 Ineffective competitors obviously do little to constrain the dominant
firm's pricing behavior. The effect of potential competition depends on the
susceptibility of a market to "hit-and-run" entry. See William Baumol, John
Panzar and Robert Willig (1982).


competition and harms consumers. The government should replace its
asymmetric rules with symmetric ones, and adopt regulatory procedures that
foster price competition rather than facilitate recognition of mutual

interdependence among oligopolists.

The Dominant-Firm Model

Consider an oligopolistic market in which there is one large firm (the
“dominant firm") and several smaller firms (the "competitive
fringe").2 This kind of market structure can be analyzed using a model,
which, in contrast to many other oligopoly models, yields determinate
solutions for prices and outputs. It does this by melding elements of
monopoly and competition in a way that limits the need for analysis of
strategic interdependence, the differentiating characteristic of oligopoly
which typically leads determinate solutions to "fade into a mist of

interacting uncertainties. 3

The trick is accomplished by assuming that one firm behaves as a

price-searcher and the others as price-takers. The price-searcher finds a

2 Oligopoly is "competition among the few." See William Fellner (1949).
The dominant-firm model was originally postulated by Karl Forchheimer
(1908). Our exposition follows the treatment in James Quirk (1976, pp.
274-75).

3 See Jack Hirshleifer (1976, pp. 323-325).


on their ability to utilize different earriers' services, they are harmed by
artificial restraints on carriers’ ability to offer them services that
satisfy their requirements. "Equal access" is a two-way street. Ina
market environment in which no firm is dominant, no asymmetries in the

regulatory treatment of supplier access to customers can be justified.

Considerations related to the possibility of oligopolistic coordination
yield similar conclusions for policy. The economic structure of the
long-distance business in many respects resembles that of the automobile
industry. The structure is oligopolistic with a relatively small number of
(facilities-based) suppliers competing for consumers! favor. Substantial
investments in sunk capital assets are required for effective participation.
On the one hand, this implies a limited role for potential competition to
influence market performance. |! On the other hand, it suggests little
possibility for effective predation as exit from the market is unlikely once

capital has been sunk.

V1 Note, however, that the fungibility of productive capacity across
market segments does imply that potential competition can play a significant
role once capital has been deployed. Potential redeployment of sunk assets
acts to constrain pricing in any market segment where the threat of asset
redeployment is credible.

- 16 =


relative to the size of the market. The dominant-firm model assumes that
the former is so small relative to the latter that, on the one hand, fringe
firms ignore the effects of their actions on the dominant firm's prices and,
on the other hand, the dominant firm allows fringe firms to sel. all that

they wish.

The dominant firm's willingness to forbear is the critical conjecture
about the strategic interaction among firms under oligopoly that enables the
dominant-firm model to produce determinate outcomes. As long as what the
fringe does does not matter much, the dominant firm can afford to leave well
enough alone and simply compensate for the fringe's activities in its own
pricing decisions.> How much the fringe's activities matter depends on

the size of its supply capability relative to the size of the market.

The dominant-firm model provides a description of short-run pricing
behavior under oligopoly. That is because, in the short run, both the
number of firms and their productive assets are fixed. The dominant firm
can sustain a price above cost in the short run because, by assumption, the
fringe cannot expand its plant capacity, improve its reputation for
competence and fair dealing, or increase its numbers through the entry of

new firms. In the long run all of these things can happen in the absence of

5 Over time the dominant firm's market share will decline assuming it
bears the brunt of the burden of restricting output for the industry.
Assuming capital is sunk and long-lived, the dominant firm will thus tend to
earn a lower rate of profit than its rivals. See D. A. Worcester (1957).


and inefficacious cost allocation rules.

As price cap rules permit simplification of the piecemeal deregulation
docket proposal, the latter's reasoning permits simplification cf the price
cap rules for AT&T without a concomitant risk of harm to the public.
Because it assumes that the carriers subject to price cap regulation are
dominant in each telecommunications submarket in which they participate, the
Price Cap docket has erected machinery far more cumbersome than appears

necessary to assure that AT&T's service rates are just and reasonable.

Applied in the traditional tariff regulation setting, the piecemeal

deregulation proposal of the Basic Services Deregulation docket would have

divided AT&T's basic services into two categories: those for which the
carrier was dominant and those for which it was not. Traditional tariff
review rules would govern the former; the latter would be eligible for
streamlined review.20 When the reasoning of the Basic Services

Deregulation docket is applied in the price caps setting, it logically leads

20 This separation of services into disjoint classes to which different
regulatory rules would apply is similar to the core/noncore distinction
drawn in OPP Working Paper # 22, in which Commission staff for the first
time explored the possibility of applying price cap regulation to AT&T.
That paper presented a simple proposal for reforming the FCC's regulation
of AT&T "{tJhe essence of [which] 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." See John Haring and Evan Kwerel (1987, p. 27). OPP Working
Paper # 23 examined the legal issues raised by the Har ing-Kwerel proposal
and concluded that the proposal would withstand judicial scrutiny. See
Kathleen Levitz (1987).

- 22-




of relative supply capability from these data: the percentage of total
industry capital each firm's capital assets represent and the percentage of

AT&T's long-distance capital each firm's capital assets represent.

On the assumption that AT&T is itself capable of supplying the entire
market, the percentage of AT&T's long-distance assets a firm's assets
represent gives an estimate of that firm's supply capability relative to the
size of the market. The percentage of total industry capital a firm's own
assets represent is likely to understate its true relative supply capability
because the long-distance business is currently characterized by significant

excess capacity.7

7 Robert Crandall (1988, p. 31) has observed that "Given the history of
transportation regulation, we know that continued rate regulation and
liberalized entry are a potentially lethal combination. Regulators
inevitably find themselves hostage to inefficient competitors. It now
appears that investment in interstate telephone transmission has been
excessive. The frantic investment in fiber-optic networks reminds one of
the rush to build railroad lines in the last century. It would be
propitious for the regulators to find a way to exit before they are either
pressured to keep long-distance rates artificially high or are engulfed in a
series of politically embarrassing bankruptcies."


Ultimately, if the only thing that prevents firm B (or C or D) from
taking business from firm A is its (or their) willingness to quote a
sufficiently low price, there is no economically relevant sense in which
firm A can be said to be "dominant." At that point we pass from the
deterministic world of the dominant-firm model into the realm of
oligopolistic interdependence and genuinely strategic interaction. As that
boundary is crossed, it is important to recognize that the regulatory rules
that formerly made sense may no longer be justified. In particular, when no
firm can be uniquely categorized as dominant, no asymmetric assignment of
regulatory liabilities can be legitimately defended. A new market

environment calis for new rules.

Is_AT&T Dominant?

The question of dominance turns on a comparison of supply capabilities
relative to the size of the market. While supply capabilities may vary over
different market segments, a firm's total capitalization provides a
reasonable approximation of its overall supply capabilities and a rough

gauge of its competitive prowess.

Table 1 presents estimates of each of the major long-distance

competitor's capital assets. In addition, we have calculated two measures


Tariff filings meeting these two conditions would be eligible for
streamlined treatment. Nondominant carriers, however, are subject to no
tariff review. Prior to its price caps decision, the Commission also
prescribed the rate of return which dominant carriers were to target their
interstate services to earn and had asserted its authority to require the

carriers to refund overearnings.

The Commission also requires dominant carriers to receive authorization
to construct, acquire or operate new interstate transmission facilities, a
requirement that it does not impose on nondominant carriers. The Commission
also prescribes the rate at which dominant carriers may recover their
capital investment. Its Separations Manual, codified as Part 36 of the
Commission's Rules, 47 C.F.R. Part 36, prescribes the rules these carriers
must use to apportion investment and expenses between their interstate and
intrastate operations, rules that often require the performance of expensive
cost studies. Even under price caps regulation, AT&T's earnings on
interstate services remain the subject of periodic review and a potential
basis for adjustments to the rate ceilings. None of these rules apply to

nondominant carriers.

AT&T and the former BOC's are also required to comply with the

nonstructural safeguards of Computer Three! as a condition precedent to


(forbearance extended to domestic satellite carriers, miscellaneous common
carriers, interexchange carriers affiliated with certain independent

telephone companies and certain carriers providing DEMS).

Under the regulatory scheme created by Competitive Carrier many of the
rules with which dominant carriers must comply do not apply to nondominant
carriers. For example, a dominant carrier must continue to make a tariff
filing each time it proposes to offer a new service or to change the terms
and conditions under which it offers any service already tariffed. Before
that tariff filing becomes effective, both Commission staff and interested
members of the public (including, notably, nondominant competitors) review
the filing, as well as the often voluminous economic support required under
Commission rules. These parties often submit petitions to reject the filing
as unlawful or to suspend it while the Commission conducts a more extensive
investigation into its lawfulness. The Commission may exercise its
authority under Section 204 of the Communications Act to investigate further
the tariff's lawfulness and may delay the effective date of the tariff for

up to five months while it conducts such an inquiry.

The Commission's recent decision to adopt price cap regulation for
domiminant carriers changes the filing and review requirements for only
those AT&T tariff filings that are not associated with service contracts
following competitive bid and that propose only rate level adjustments that

comply with the applicable rate caps. see 47 C.F.R. §§ 61.41 - 61.


On the other hand, the price under this type of industry organization
is higher than would prevail under conditions of perfect competition. Thus
the possibility exists that regulation might improve the efficiency with
which resources are allocated. In particular, a regime of asymretric
regulation that effectively (and economically) constrained the dominant
firm's price to the competitive level would expand consumer welfare. It is
in this sense that the economic model of dominant-firm behavior can be used
to justify differences in the regulatory treatment of dominant and

nondominant firms.

Note that such regulation would harm (and, therefore, presumably be
opposed by) the competitive fringe. The lower the prices the dominant firm
is compelled to charge, the smaller the sales of the fringe firms. The
interest of the fringe firms is to keep the dominant firm's prices high to
provide an “umbrella” under which the fringe can expand its sales. In the
dominant-firm model the fringe's interest is clearly in regulation that
prevents prices from falling rather than in regulation that compels (or
permits) reductions in the dominant firm's prices. In terms of pricing
regulations, the interests of the fringe firms and of consumers thus

diverge.

What Makes the Dominant Firm Dominant?

The crucial factor that drives outcomes in the dominant-firm model is
the size of the fringe's supply capability relative to the size of the

market compared to the size of the dominant firm's supply capability


regulation. 14 For this reason, a decision to forbear from regulating the
rates for all of AT&T's services would not only appear to carry substantial
risk of being overturned on appeal, but might also jeopardize the
Commission's continued ability to forbear from regulating other

interexchange carriers.

Thus it appears that, to be legally sustainable, symmetric regulation
must impose unnecessary costs on some or all regulatees, not to mention
consumers. That raises the question of whether some other regulatory reform
could relieve AT&T of the disparate burden it shoulders and yet survive
judicial scrutiny? We believe that the answer is "yes." The Commission has,
in fact, already developed, albeit on a piecemeal basis, all the policy and
legal tools needed to create such reform, The essential components of

successful reform lie within two open dockets, the Price Caps proceeding '9

14 In FPC v. Texaco, 390 U.S. TAT (1968) the Supreme Court held that
while the Federal Power Commission could not rely exclusively upon market
forces to achieve just and reasonable rates for small natural gas producers,
it did not have to fix these rates through orders directly addressed to
these producers, but could instead rely upon indirect regulation of their
rates through orders setting the rates of the large producers. The FCC has
repeatedly recognized a need to show that its decisions first to streamline
regulation of and then to forbear from regulating nondominant carriers were
consistent with the holding of Texaco. An essential component of its
argument that nondominant carriers’ rates would be just and reasonable was
that the Commission-regulated rates of AT&T acted as a cap on the rates that
these carriers could effectively charge for their services.

15 Policy and Rules Concerning Rates for Dominant Carriers, CC Docket No.
87-313, Notice of Proposed Rulemaking, 2 FCC Red 5208 (1987), Further Notice
of Proposed Rulemaking, 3 FCC Red 3195 (1988), Report and Order and Second

Notice of Proposed Rulemaking, FCC 89-91 (Released: April 17, 1989).

- 19 -


In this paper we have described how the FCC, having adopted a system of
price caps to regulate AT&T, is now well positioned to proceed witi.
additional reform that can help to promote a more competitive marketplace
for long-distance services and thus expand consumer welfare. The key to
such reform lies in the creation of core and noncore service categories
within the Commission's price caps regime for AT&T, with streamlined

regulatory treatment afforded an expansive class of noncore services.

- 25-


If the commission looks hard at the marketplace
realities, there would be very little basis for a

conclusion that AT&T is a nondominant ecarrier.¥*/

Gerry Kovach, MCI Senior Vice President for

Regulatory and Public Policy

We beat AT&T on this one. This contract is just the
beginning. MCI will announce five or six other large
network coups--particularly for large data

applications--over the next 90 days.*/

Ronald E. Spears, President, MCI Midwestern

Division

*/These quotations appear in two different stories on the same page (41) of

the 1/9/89 Communications Week.


self-serving attempts to sustain an outmoded regime of asymmetric regulation

that supplies competitors with protection from competition.

Oligopoly and Regulation

The market equilibrium under oligopolistic industry organization is
uncertain. It depends on how firms interact and, thus, different
assumptions about the strategic interaction among competitors yield
different conclusions. Competitive outcomes are a possibility under
oligopoly. So are monopolistic ones. What results actually obtain will
depend on a variety of factors, not least important the regulations that

govern the behavior of market participants.

Following Bertrand (1883), suppose price is the focal point of
competitive rivalry among oligopolists and that each firm takes the price
chosen by its rivals as a given. For each firm the optimal strategy is to
set a price just infinitesimally lower than its rivals' because the firm
quoting a lower price attracts all the business. But if all firms behave
that way, the equilibrium price is established at the competitive level as
firms continually undercut one another until price cutting is no longer

viable.

- 12-


The modern theory of oligopoly (see George Stigler 1964 and Gary Becker
1968 and 1971) focuses directly on the benefits and costs of collusive
behavior among competitors. The gains from collusion (tacit or explicit)
are negatively related to elasticities of demand and supply. The costs of
colluding (i.e. of taking effective recognition of mutual interdependence )
are lower the smaller the number of firms and customers, the less erratic
the shifts by customers from one firm to another, and the less hostile
government legislation and regulation are to collusive behavior. The theory
predicts that noncompetitive outcomes are more likely to occur the greater

the net gains from cooperative behavior among competitors.

A regulatory agency whose tariffing procedures and requirements are
easily subverted to inhibit competitive responses and could, in principle,
supply a clearing house for competitively sensitive information that would
facilitate oligopolistic coordination can hardly be characterized as hostile
to anticompetitive behavior. The fact that such misuse would constitute a
perversion of governmental process does not render the process itself any
less noxious. Fundamental reforms, ineluding abolition of the tariffing
process for some services, unfortunately require legislative changes that
are likely to be a long time coming if they ever come at all. There are,
however, less radical reforms that can help prevent the Federal
Communications Commission from being transformed into a Federal

Communications Cartel.

- we


WHAT MAKES THE DOMINANT FIRM DOMINANT?*

John Haring**

Kathleen Levitz**

* The views expressed in this paper are those of the authors and are not
meant, nor should they be construed, to reflect those of the Federal
Communications Commission, any individual Commissioner, or any other member
of the Commission's staff.

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


to the separation of AT&T's services into two slightly different disjoint

categories, which we shall refer to as core and noncore respectively.

Noncore services would still include those services for which "the
competitive process assures that customers will receive the types of
services they require at reasonable prices."2! They would be afforded
streamlined treatment while core services would remain subject to price cap
regulation.22 Under price cap regulation, however, it should be possible

to expand the set of noncore services eligible for streamlined regulation.

If each AT&T service is grouped with all of its close AT&T substitutes,
and if the Commission's price cap rules are applied to even one member of
each such class, the price cap has the same effect on all other members of
that class that market forces exert upon fully competitive noncore services,
i.e., reasonable rate levels. This ability of price cap regulation to act
as a (perhaps largely redundant) surrogate for market forces permits the
inclusion of all but one member of each class of "close" AT&T service

substitutes in the noncore category .23

21 Id. at 650. Thus, for example, service offerings now included within
AT&T's Tariff No. 12 would be categorized as noncore.

22 Applying the regulatory scheme adopted in the price cap docket to our
proposal would require each "core" service to be in its own basket, that is,
each core service would be individually capped.

23 Thus, if MTS were designated a "core service," optional calling plans

like "Reach-Out America" and "Pro-America" would qualify for streamlined
tariff review.

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LIST OF REFERENCES

Baumol, William, John Panzar and Robert Willig, Contestable Markets and the
Theory of Industry Structure (1982).

Becker, Gary, "Crime and Punishment: An Economic Approach," Journal of
Political Economy (April 1968).

, Economic Theory (1971).

Bertrand, Joseph, "Théorie mathématique de la richesse sociale" (review),
Journal des Savants (September 1883).

Case, James, Economics and the Competitive Process (1979).

Cournot, Augustin, Théorie Mathématique de la Richesse Sociale (English
Edition: 1897).

Crandall, Robert, "Telecommunications Policy in the Reagan Era," Regulation
(1988) Number 3.

Fellner, William, Competition Among the Few (1949).

Forchheimer, Karl, "Theoretisches zum unvollstandigen Monopole," Schmollers
Jahrbuch (1908).

Haring, John and Evan Kwerel, "Competition Policy in the Post-Equal Access
Market," OPP Working Paper Series, No. 22 (February 1987).

Hirshleifer, Jack, Price Theory and Applications (1976).

Levitz, Kathleen, "Loosening the Ties That Bind: Regulating the Interstate
Telecommunications Market for The 1990's," OPP Working Paper Series,
No. 23 (February 1987).

Quirk, James, Intermediate Microeconomics (1976).

Scherer, F. M., Industrial Market Structure and Economic Performance (1980).

Stigler, George, "A Theory of Oligopoly," Journal of Political Economy
(February 1964).

Worcester, Dean, "Why ‘Dominant Firms' Decline," Journal of Political
Economy (August 1957).


Table I

Long Distance Capital Assets */

1988 $Billions 4% Total 4% AT&T

AT&T $8.0EF 40% 100%
MCI $5.88 29% 71%
U.S. Sprint $3.5 8A 184 4g
Other **/ $ 2.5E 13% 31%
Total $19.8 E 100% 246%

%/ Source: Lap Lee, Salomon Brothers.

**/ Does not include the value of private networks.

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Alternatively, following Cournot (1897), suppose output decisions are
the focus of competitive rivalry and that each firm takes the output chosen
by its rivals as a given, Equilibrium in this kind of model occurs when the
profit-maximizing outputs firms select coincide with those their rivals
expect them to select (i.e., their expectations are consistent and mutually
reinforcing). This is an equilibrium in the sense that no firm has an
incentive to change its output so long as its rivals maintain theirs. When
firms are symmetrically situated, the Cournot equilibrium involves a
price-output combination that is, from consumers' standpoint, superior to

monopoly but inferior to perfect competition.

There is considerable dissatisfaction among economists with most models
of oligopoly. That is, in part, because competitors are (or should be)
smarter than oligopoly models generally give them credit for being. Instead
of undercutting one another, Bertrand's competitors should be able to see
that cooperation (i.e., collusion) to maintain a high price will maximize
joint profits. Instead of taking rivals’ outputs as fixed (in the face of
repeated evidence to the contrary in disequilibrium), Cournot 's competitors
should learn from experience and comprehend the payoffs to be reaped by

cooperation and coordination of supply (i.e., collusion).9

9 One of the leading modern exponents of Cournot's ideas observes that
"“Cournot's players persist in behavior which reveals the untruth of the
assumptions which prompted the behavior in the first place. Rational
players, by comparison, would come quickly to anticipate each other 's
reactions and would alter their behavior until events confirm (rather than
deny) their expectations." See James Case (1979, p. 31).

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