also frequently financed by a mandatory assessment on all property
owners in addition to fees based on volume of use. In contrast,
electric, gas, and telephone companies generally cannot impose fees on
all property owners, but often have two part tariffs (with a fixed
system tee for receiving any service plus a fee based on usage) for

those who choose to subscribe.

So long as a very high percentage of potential subscribers choose
to subscribe to the utilities, there is little financial difference
between a mandatory fixed fee and a fixed fee imposed only on
subscribers. But whether the fixed fee is mandatory or charged only to
subscribers is an important distinction when considering the effect
of a pricing structure on the degree of universal service. Universal
service in roads is provided by force of law; roads are built and
financed by tax revenue and a building permit may be denied for a
location with no access to roads. Consequently, consumers do not have
the opportunity of deciding whether access to roads is to them worth
their share of the cost of the road system. Because access and
payment for telephones is not mandatory, the percentage of people who
choose to subscribe will be affected by the prices used to distribute

the costs of the system over all subscribers.

Prior to the introduction of telephone competition, the total

revenue collected was limited by rate of return regulation, but no


The cost characteristics of telephone service are similar to
those of a public good.12 Most of the costs are fixed by the decision
to provide a network capable of connecting all the individuals of
a given area with each other. Providing the capability to connect
all the individuals of an area requires an extensive set of switches,
feeder cables, and drop wires, whether or not any particular
individuals utilize the service. The marginal cost of serving any
one individual in isolation is very high (requiring a special cable
from the central office to that location), but the marginal cost of
serving any particular individual in an area already wired for service
is very low. There is no single well defined marginal cost of access;
rather, the marginal cost depends upon the unit of observation and
the time period considered. Consider, for example, the marginal cost
of access for a new subdivision built on farm land that had no
previous telephone wiring. There is a well defined marginal cost
for wiring the entire subdivision. Dividing the marginal cost of

the subdivision by the number of houses gives a reasonable proxy for

12 A pure public good is one in which the costs are independent of the
number of users. The standard example is national defense. Many goods
have public goods characteristics over a range of demand but are not pure
public goods. In many areas of the country, highways are effectively a
public good because they are so uncongested that an additional user imposes
no additional cost. But highways are not public goods in Washington D.C.
at rush hour because an additional user increases the congestion and reduces
the utility of the road to other users.

-27 -


increase in the total price of local telephone communication.
Consequently it will induce a 10 percent decrease in the quantity
demanded (by the assumed elasticity of -2.0). This means that a 50
per cent increase in the local price resulted in a 10 per cent decrease
in the quantity demanded yielding an inelastic demand of -0.2 for the
local telephone service. By the same reasoning, the derived elasticity
of demand for long distance service for this person is -1.0, half the
elasticity for telephone communication and five times the elasticity
with respect to local telephone usage price. This example is
consistent with econometric estimates which show local service demand

much less elastic than long distance demand.7

7 For a comprehensive summary of telecommunications demand estimates
in various market segments, see Lester Taylor, Telecommunications Demand:
A Survey and Critique (Cambridge, Mass.: Ballinger Publishing Company,
1980). For a survey of issues involved in measuring local demand and some
specific results see Charles River Associates, Demand for Local Telephone
Services upon the Introduction of Optional Local Measured Service (LMS)
(Boston, Mass.:, 1982).

- 23 -


built, and if so how will the cost be distributed?

The sum of benefits is $2 and the total cost is $1; thus the
system is feasible. In this symmetric case, the natural way to split
the cost is for each person to pay $.50, leaving each person with a
net benefit or consumer surplus of $.50, but that is not the only
solution. In this case, neither person can achieve any positive
surplus alone. Thus each person is better off to accept any positive

surplus than to refuse to participate.

Because neither person can achieve any positive payoff alone, the
core consists of all feasible allocations of the surplus. It can be
represented by a line segment extending from the point (0,1) to the
point (1,0). The solution point is indeterminate within that segment;
it is possible to have one person pay the entire cost of the system and
gain no net benefit while the other person Pays no cost and enjoys the
entire net benefit. Although such a solution may seem unfair, it is
in the core because the disadvantaged Person has no recourse other than
to refuse to participate. Because refusing to participate leaves the
person with a net surplus of zero, refusing to participate makes him

no better off than being stuck with the entire cost of the system.14

14 That the core is a range of values in a two person game is an expected
result consistent with core analysis in other markets. In the Edgeworth

-~32-




cannot always make the right choices. Free entry gives entrepreneurs
an option to challenge the decisions of the established firm by
attempting to make a profit on an alternative perception of the correct
product mix or pricing structure. But such entry is only useful if
the industry is operating within a reasonable price structure. It does
not require new entrants to inform us that the current access charges
are above the costs of service. Any analyst of the issue is already
aware of that fact. In order to make open entry serve its proper
information generating function, the existing prices must be

restructured into a more rational form.

A second reason for supporting open entry is that the industry
boundaries are changing. Even though basic local service has natural
monopoly characteristics, there are many areas in which local service
competes with non-regulated alternatives. The wisdom of limiting the
monopoly boundaries by the open entry policy for terminal equipment has
been amply demonstrated by the rapid pace of innovation and competition
in that segment. Yet there is no clear demarcation between terminal
equipment and other parts of the network. A large PBX is essentially
a small central office. Lines from a PBX to extension telephones
("inside wiring") are functionally indistinguishable from access lines
connecting telephones with local offices. In order to maximize
opportunities for innovative use of the telephone network, it is

necessary to allow individuals a great deal of freedom to construct

-62-


allocative efficiency to some degree.

fase 2: No Discrimination Limitations but Interconnection Required

So long as no limitations are placed on price discrimination, the
company with whom interconnection is desired can charge an arbitrarily
high price to stop interconnection. Alternatively, it can charge a
price equal to the benefits it would have received if there had been
no separate system. Assume, for example, that a “smart building"
connects together 40 customers, each of whom previously produced $20 a
month in revenue above marginal cost, and then attempts to connect the
combination to the telephone company as a single customer. If the
telephone company is able to charge $800 above marginal cost for the
interconnection, then it generates the same contribution to fixed cost
from the customers of the smart building as it did from retaining them
as individual customers. Consequently, the interconnection

requirement is ineffective and this case is equivalent to the first

case.
Case 3: Price Discrimination Prohibited, Interconnection not Required

In this section we assume that the existing company specifies a
price structure and must follow that price structure for any customer

that it chooses to serve, without discrimination. However, there is

- 42 -


them to join the network, but such prices leave little net consumer
surplus to be distributed. In the example above, both the price for
Person 5 and the additions to the prices of other subscribers were
determined within narrow limits by the fact that person 5’s total
direct and indirect benefit was 42 while the marginal cost was 40,

leaving only 2 units to be distributed among the five people.

We conclude that with no limitations on price discrimination and
with no interconnection requirements, the costs will be allocated
toward those customers who value the network most highly. There will
not be a single cost allocation but rather a wide variety of stable
cost allocations in the core. However, the subscribers who value the
network near the marginal cost of serving them will not bear any of the
fixed costs of the network, nor will they necessarily even bear the
entire marginal cost that they impose. Any customer for whom the
direct plus the indirect value of subscription is at least equal to the
marginal cost of service will be on the network. If the valuations
are continuously distributed, ranging down to very low valuation (and
there is a high degree of connectivity among the participants), any
network which charges every customer at least that customer’s marginal
access cost will be displaced by another network with more
discriminatory pricing. For high value customers, there is no rule
that determines the allocation of costs among them. Two customers who

value the network equally may be charged very different costs and still


price structure of the 1960’s (with prices not at all closely related
to telecommunications costs), it is unlikely that competition would
have been successful without a requirement to interconnect. The only
successful entry without interconnection has been in cases where there
was no previous service availability (such as small towns after the
expiration of the original Bell patent that had not been offered
service by the Bell companies) or where the customer had a high volume
of demand for communication among a small number of locations (such

as private microwave systems for internal company communications).

Case 4: Non-Discrimin atory Pricing, Full Interconnection, and Obligation
to Serve

The first three cases illustrate that neither interconnection
requirements nor non-discrimination requirements place significant
constraints on the carrier’s pricing freedom. The first three cases
are essentially alike in showing a large variety of feasible
equilibrium allocations of the costs among the various parties. Even
with free entry, the interconnected nature of telecommunications and

the large role played by fixed costs leaves wide latitude for

- 48 -


The Commission has been reducing the problems created by the high
usage charges on long distance access by switching some of the revenue
requirement to local fixed charges. A charge of up to $6.00 per line
per month for multiline business customers was imposed in 1984; a
charge of $1.00 per line for residential and single line business
customers became effective in June 1985, and an additional charge of
$1.00 per line is scheduled to begin in June 1986. However, even after
the 1986 charges are in place, substantial usage based long distance

access charges will remain.

The essential lesson of the economic analysis contained in this
paper is that in order to have efficient free competition, without
price discrimination and with an obligation to interconnect all
telephone systems, the fixed costs of the telephone network cannot be
arbitrarily assigned to any one element of service. To avoid
uneconomic bypass, long distance access usage charges must be reduced
to the level of other local usage charges. To avoid uneconomic
substitution of PBX connections for direct access to the local
telephone company, fixed local access charges must be limited to the

cost of substitutes.20

20 At present the constraint that fixed local access charges be limited
to the cost of substitutes is not very restrictive. Even if the entire

-52-


additional value from the larger network to compensate for the higher
price they are charged. If there were another potential customer with
total direct plus indirect value less than the marginal cost of access,
then any network which attempted to serve that customer could be
displaced by another one that dropped that customer from the network

because the customer would be causing more total costs than total

benefits. .

With a large number of customers of varying sizes, all prices that
are sustainable against entry will induce any customer to join the
network for whom the direct plus the indirect benefits of that
customer’s participation are less than the marginal cost imposed by
that customer’s participation. The sum of direct benefits for all
participants is necessarily equal to the sum of indirect benefits
because both sums are simply the total of all entries in the value
matrix. However, there is no necessary relationship between the direct
and the indirect benefits for any one individual. It is possible to
have a person who greatly values communication with other people but
with whom no other person values communication, or vice versa. If the
average conditions hold true in individual cases, 80 that the direct
benefits are equal to the indirect benefits as in the example above,
then the optimal pricing rule will be to charge the marginal customer

exactly half of the marginal cost of access.

- 38 -


freedom, the less freedom the telephone company has to allocate its
fixed costs among services. The beginning of private microwave did not
harm AT&T“s ability to earn its authorized rate of return, but it did
imply that more of the fixed costs of the network would be borne by

customers other than large users of private line circuits than before.

Assuming the Telpak tariffs were above AT&T’s marginal cost as
AT&T claimed, other customers were better off with the Telpak customers
on the network at the Telpak prices than with them off the network.
But the other customers were not better off than they would have been
had the Telpak customers remained on the network at the old prices.
The private microwave authorization and Telpak response rearranged the
allocation of fixed costs, reducing the amount paid by large private
line users from its previous level. The restraints on the company’s
pricing freedom come from the consumer’s maximum value from remaining
on the network, either because of other alternatives or because of low

total valuation of telephone service.

Although the Above 890 decision placed some restrictions on the
set of feasible prices, its effect was limited because of the narrow
set of customers who could utilize bulk private line service. The two

crucial decisions which greatly shrank the set of feasible prices were

~10-


the marginal cost per house, but that “average marginal cost" will
be quite different from the marginal cost of any particular house
alone. The marginal cost for wiring one house will be higher than
the "average marginal cost" if no other houses are being wired, and
will be lower than the “average marginal cost" if all other houses

are being wired.

The dependence of marginal cost upon the unit of observation
is similar to the problem of measuring marginal cost of airline travel
Per passenger. A single passenger in isolation imposes a very high
marginal cost (the cost of sending an airplane), while a single
additional passenger on a flight that is not full imposes a very small
marginal cost (the extra fuel for additional weight and possibly a
meal). Similarly, telephone cables come in conventional packages (50
pairs, 300 pairs, etc.) and the utilization of an additional wire pair

within a cable imposes practically no marginal cost.

An additional consideration for telephone marginal cost is the
time perspective. Telephone plant is a long lived capital good with
limited salvage value. Once a house has been provided with
telephone service, including a drop wire and inside wiring, the
capital necessary to provide that service will normally remain in
Place even if service is discontinued. Although the feeder cable

could be reallocated to another customer, the telephone companys

- 28 -


which are beyond the scope of this paper.24

VII. Conclusion

Free entry combined with a non-discrimination requirement and an
interconnection requirement puts a severe constraint on the pricing
freedom of local companies. However, the companies can remain viable
under those conditions so long as they are allowed to adjust their
pricing structure to the competitive requirements. The alternative to
allowing pricing adjustments is to attempt to solve the current
problems through increased regulation. Long distance access bypass
and smart buildings can be prohibited or taxed in an attempt to
maintain the existing price structure. But there are great advantages

to allowing free entry.

A prime function of entry is to produce information, including
information that indicates the existing firm has made mistakes.

Especially in a dynamic industry such as telecommunications, one firm

24 For a discussion of some of the federalism issues in
telecommunications, see Peter K. Pitsch, "Harmonizing Deregulation and
Federalism: A Conservative Dilemma," in J. R. Foster, et. al. eds.,

Boundaries Between Competition and Economic Regulation (Washington, D.C.:
Institute for Study of Regulation, 1983), pp. 71-81.

-61-


Telephone Pricing to Promote Universal Service and Economic Freedom

Gerald W. Brock!

Office of Plans and Policy
Federal Communications Commission
Washington, D.C. 20554
January 1986

1 The opinions and conclusions expressed in this paper are those of the
author alone. They do not necessarily reflect the views of the Federal
Communications Commission or any of its staff other than the author. The
author appreciates the comments and suggestions of Peter Pitsch, Tom
Spavins, Evan Kwerel, Kenneth Gordon, Florence Setzer, Jon Levy, Lex Felker,
and John Haring of the Office of Plans and Policy and Peyton Wynns of the
Common Carrier Bureau. None of the above individuals is responsible tor any
errors in this paper.




alternative Communication systems and to interconnect them with the

public network without discrimination.

The increasingly close association of the computer and
telecommunications industries Suggests that no sharp boundary exists
between them. Many products could come out of either the regulated
communications industry or the unregulated computer industry. Any
attempt to solve the current bypass problem or related problems of
Potentially uneconomic entry through entry prohibitions will create
artificial walls around certain services and reduce the Possibilities
for innovative use of the telephone network. But @ policy of open
entry together with price Structure reform will lead to maximum
consumer freedom together with economic efficiency and Protection of

universal service.

- 63 -


large bundle of goods for each customer. It is analogous to the common
practice of pricing delivery service for appliances, lumber and so
forth at a flat rate for a given radius from the store. The actual
costs of delivery will vary within the area but the transactions costs
of setting up a more precise delivery charge are not justified by the

improvement in pricing accuracy.

Because demand for telephone service is demand for communications
from specific points to specific other points, the total market demand
consists of a matrix of individual demand curves. Each entry in the
matrix, dij, represents the demand curve for communications from
location ito location j. These are ordinary demand curves based
strictly on the characteristics of person i with no dependence on the
decision of person j to subscribe. Whether that demand is satisfied or
not depends upon whether persons i and j both subscribe to a network
which allows them to communicate, but person i may have demand for
communication with j even if that demand is not satisfied. The
externality only arises for the composite good "communication from
location ito all locations connected with a particular network."
That composite good is formed by summing the demand curves 4ij over
all persons j attached to the network and obviously depends on which

persons are attached to the network.

~21-


competitive forces or arbitrage forced prices to conform to the pattern
of costs. Individual customers had the choice of paying the required
tariffs, doing without service, or seeking to change the tariffs
through the political process. Consequently, the prices became more
subject to political strategies than to market forces. Because the
"pie" of costs could be allocated in many different ways without
inducing significant consumer drop off, the political forces were

focused on the distribution of costs among different customer segments.

The basic price structure that evolved was a fixed charge per
month for local service and a usage charge for long distance service.
An increasing portion of the long distance service revenue was paid
back to the local companies over time, gradually reducing local rates
and increasing long distance rates over what they would have been if
the allocations had remained constant. Because technological progress
reduced the cost of long distance service while inflation was
increasing the cost of local service, the shifting of revenues from
long distance to local helped preserve the status quo and slow down
the rate of price change. In the absence of competition, practically
any politically attractive allocation of costs was feasible because

consumers had little option other than to pay the assigned prices.

In more formal terms, the "core" of the cost allocation game was

extremely large. The core is defined as the set of allocations among


Far more significant than the immediate changes in the PBX and
private line market brought about by the Carterfone and the MCI
decisions was the unforseen effect of the combined decisions. Each
decision individually opened up a piece of the market to competition.
But together, they provided the possibility of connecting MCI’s private
line microwave network to the local switched network through a PBX.
Such a connection would allow anyone to place a local call to the MCL
office that would proceed as any other local call to MCI’s PBX, then be
switched out over the MCI long distance system to the destination city,
then forwarded to the final recipient via another local call. The
privately owned PBX would therefore serve as the equivalent of a
central office. It would transform MCI“s microwave facilities into
the equivalent of a public switched network that could be accessed from
any telephone. MCI packaged such an arrangment as a "shared private

line service" called Execunet.

The Execunet service was an unexpected entry composed of perfectly
legal components packaged to provide an alternative to ordinary MTS
and WATS service. MCI was entitled to use a PBX to send and receive
local calls and it was entitled to use its microwave network to
transmit long distance messages. But when it combined the two together
to provide competition to MTS service, the Commission rejected the

service as outside of MCI’s operating authority. When that decision

-13-


1

event was the Above 890 decision! that allowed private companies to
establish microwave communication systems. With private microwave,
it was possible for companies with a large volume of communications
among their own offices to construct a private network. The existing
price structure provided no volume discounts and assigned higher prices
to a large number of circuits than the cost of providing equivalent
circuits with private microwave. Consequently, once private microwave
was available, the existing price structure was no longer a "core"
allocation because a subset of customers (businesses with high volume
internal communications) could construct an alternative system (private
microwave) more cheaply than they could lease private lines from AT&T.
However, even though the cost of private microwave was less than AT&T’s
price, the cost of private microwave was not necessarily less than the

cost to AT&T for provision of the service.

AT&T responded with a price structure change in the form of the
Telpak volume discounts that reduced the price tor the targeted
customers to within the level of private microwave costs. The
increased opportunities for customers translated into a restriction

on pricing freedom for the telephone company. The greater the consumer

Allocation of Frequencies in the Bands Above 890 Mc., 27 FCC 359
0).

(1959), recon. denied, 29 FCC 825 (196


The demand for telephone communication between any two points is a
derived demand based on the underlying demand for communication between
the two points. The elasticity of that demand is consequently
dependent upon the price of the inputs other than telephone service
that are used to fulfill the demand for communications, and is also
dependent upon the price of alternative means of communication that
do not require telephone service. For voice communication, the most
important input is the time of the people conversing. For practically
all local calls and for many long distance calls the time cost of the
conversation is far more significant than the telephone cost. Time
costs are also crucial in determining the feasibility of substitute

means of communication such as personal visits or writing letters.

The elasticity of demand for telephone service is derived from
the elasticity of demand for telephone communication and the proportion
of the total cost of telephone communication accounted for by telephone
service. For example, assume that the elasticity of demand for
telephone communication is quite elastic with a value of -2.0. Assume
the person’s time value is $9.00 per hour and the usage charge tor
local measured service is $1.00 per hour while the usage charge tor
long distance service is $9.00 per hour. Then the total cost of
telephone communication to that person is $10.00 per hour for local and
$18.00 per hour for long distance calls. A 50 per cent increase in the

local price increases it by $.50 per hour and is only a 5 per cent

-22-


economic efficiency. However, the local companies cannot move to the
more stable price structure on their own, but must have regulatory help
in the form of changes in the separations allocations and access

charges.

Il. The Origin of Current Pricing Problems

The telephone system is comparable to a system of public roads. \
very large investment in public roads is necessary to allow people to
move treely from one place to another, regardless of the volume of
traffic. As traffic increases, costs increase (to upgrade a two lane
highway to a multilane controlled access highway, for example), but
many of the costs are incurred simply in providing access to
practically anywhere. The value of the roads increases with the range
of places to which they reach, as does the value of complementary goods
such as automobiles. If the road network is very limited, as in Alaska
or in many developing countries, then people must use alternative means
of transportation and the roads which exist have lower value than they

would in a more fully developed system.

Roads, telephones, and local distribution systems for water,
natural gas, and electricity have similar economic characteristics.

Their costs are largely determined by the number and specific locations

of the places they reach, rather than by the total volume of traffic.


Recent Working Papers & Staff Reports
° ce of Plans and Policy
Federal Communications Commission

Promoting Competition Between International Telecommunication
Cables and Satellites

by Evan R. Kwerel and James E. McNally, Jr.; Working Paper #19
January 1986

Telephone Pricing to Promote Universal Service and Economic Freedom
by Gerald W. Brock; Working Paper #18, January 1986.

The FCC, The OCCs and the Exploitation of Affection
by John Haring, Working Paper #17, June 1985.
NTIS # PB85 234250/AS; $7.00 pp. 16

Using Auctions to Select FCC Licensees
by Evan Kwerel and Alex D. Felker; Working Paper #16, May 1985.
NTIS # PB85 214484/AS, $8.50 pp- 33

Spectrum Management Policy in the United States: An Historical Account
by John 0. Robinson, Working Paper #15, April 1985.
NTIS # PB85 204550/AS; $14.50 pp. 72

Implications of Asymmetric Regulation for Competition Policy Analysis
by John Haring, Working Paper #14, December 1984.
NTIS # PB8S 147254/AS, $8.50, pp- 40

Promoting Competition Piecemeal in International Telecommunications
by Evan Kwerel; Working Paper #13, December 1984.
NTIS # PB85 151223/AS; $10.00; pp. 54

Bypass of the Local Exchange: A Quantitative Assessment
by Gerald W. Brock; Working Paper #12, September 1984.
NTIS # PB85 107811; $11.50; pp- 93.

Divestiture and the Separate Subsidiary Requirement
by Florence 0. Setzer; Working Paper #11, March 1984.
NTIS # PB84 186824, $4.50; pp. 42.

The Effects of Higher Telephone Prices on Universal Service
by Kenneth Gordon and John Haring; Working Paper #10, March 1984.
NTIS # PB84 186790; $4.50; pp. 45.

A Framework For a Decentralized Radio Service
by Alex Felker and Kenneth Gordon, September 1983.
NTIS # PB84 101609, $10.00; pp. 55.

A COMPLETE LIST OF OPP PAPERS IS AVAILABLE UPON REQUEST.

ABOVE PUBLICATIONS MAY BE ORDERED FROM NTIS BY MAIL OR TELEPHONE. PLEASE
INCLUDE NTIS NUMBER (SEE ABOVE) WHEN ORDERING.

National Technical Information Service
5285 Port Royal Road

Springfield, VA 22161

703/487-4650



by connecting to a single PBX and order service as one customer from
the phone company. The usage fee would remain the same. If the cost
of the effort to combine is lower than the access charges imposed on
the tenants individually, the access charges will fail the test for

sustainability.

The potential nonsustainability of using fixed access fees to
recover the fixed costs of the network arises from two factors. First,
fixed the access charges are the same across customers while the actual
product of access has different costs. Consequently, the prices must
be set at the lowest cost of all the various products in order to
achieve sustainability. The same prices that would induce tenants in
the same building to combine their traffic in a shared PBX would not
induce widely scattered businesses to combine into one unit. Second,
the fixed price is designed to recover costs spread throughout the
Network, but is charged only to the final end element. Thus the
telephone company does not save ail the costs which would have been
paid by the various tenants” access fees when the tenants combine into

one customer.

Because the competitive conditions assumed for this case are
stringent, a sustainable price structure must place the revenue
requirement on the parts of the service that cause the costs and have

no lower cost alternative. In local service, the least alternatives

- 50 -


the purpose for which they were used. Its viability was consequent ly
dependent upon the local companies” possession of adequate monopoly
_Power to prevent competitive access provision and also dependent upon
the companies’ ability to monitor usage and prevent arbitrage between

facilities charged a low rate and those charged a high rate.

The ENFIA tariff principle of using price discrimination to
maintain the existing system of payments from toll service to local
companies was the model used for initial access charge tariffs after
the divestiture. The divestiture replaced the settlements process with
access charge tariffs but initially did not greatly change the flow of
funds from long distance companies to local companies. The access
charge tariffs were set at a high enough rate per minute to earn
revenue similar to the pre-divestiture settlements level. However, at
that level some companies were required to pay more than the cost of
alternative private facilities, creating incentives to bypass the
switched access service provided by local exchange carriers. Such
bypass reduces revenues far more than costs because the access tariffs
are designed to provide substantial support for total local exchange

facilities.

Because the existing price structure is not stable, the paper
examines the alternatives available to raise the needed revenue without

driving people off of the network. After an extensive analysis of


network. Using that definition, demand from one person depends upon
the choices of others to subscribe. That creates an externality which
has been extensively discussed in the economics literature.6 However,
the externality is a function of the definition of the product rather

than an intrinsic characteristic of telephone demand.

A person’s demand for telephone service in a particular network
is a derived demand resulting from the person’s demand for telephone
communication with specific individuals. Each person has a large
number of demand curves for telephone communication with specific
individuals. There is no externality involved in those individual
demand curves. A person’s demand for service trom any particular
telephone network is the sum of that person’s demand curves for
communication with the individuals who can be reached on that network.

Some of the individual demand curves may be probabilistic or contingent

6 A demand externality exists whenever one person’s demand for a good
depends upon the amount of that good purchased by some other person. Major
studies of the externality aspect of telephone demand appeared in a series
of articles in the Bell Journal of Economics including R. Artle and C.
Averous, "The Telephone System as a Public Good: Static and Dynamic
Aspects,” (Spring 1973): 89-100; L. Squire, "Some Aspects of Optimal Pricing
for Telecommunications,” (Autumn 1973): 515-525; J. Rohlfs, "A Theory of
Interdependent Demand for a Communications Service," (Spring 1974): 16-37;
and S. CG. Littlechild, "Two-Part Tariffs and Consumption Externalities,”
(Autumn 1975): 661-670.

-19-


The type of rate structure described above is already being
implemented in many jurisdictions. For example, the C&P Telephone
rates for Northern Virginia residential customers include a choice of
three plans: (1) $5.00 fixed charge plus $.106 per outgoing call, (2)
$9.20 fixed charge plus $.106 per outgoing call after the first 50
calls, (3) $16.48 per month for unlimited local service. This is
equivalent to a revenue function with an initial charge of $5.00 for
access, a charge of $.106 per call for the first 40 calls, a charge of
0 for calls between 40 and 50, a charge of $.106 per call for calls
between 51 and 119, and a charge of 0 for calls above 119. It is
essentially a small fixed charge with a volume discounted usage charge.
The present general approach of self selecting "economy" and
"unlimited" tariffs could easily be adapted to generate the revenue
currently obtained from long distance without any increase in the fixed
charges for economy customers and consequently without any diminution

of universal service.

The income distribution effects of moving some revenue requirement
from long distance access usage charges to all local usage charges
would be relatively neutral. One criticism made of the Commission’s
efforts to substitute fixed subscriber charges for usage charges was
that the change would benefit heavy long distance users at the expense
of low volume users. Moving some revenue requirement from long

distance usage to all usage will have no income transfer effect on

-37 -


interexchange carrier, the total capacity connecting an interexchange
carrier and the local exchange carrier, and a modified minutes of use
allocator that includes a substantial volume discount for traffic
between interexchange carriers and individual final users.

(2) Use regulatory tools to limit competition with the local exchange
carrier in order to protect the existing price structure. Proposals
for regulatory limitations include taxing or prohibiting private bypass
facilities, prohibiting AT&T from substituting special access for
switched access, and prohibiting resale of local services in order to
discourage smart building competition.

(3) Substitute an increased subscriber line charge (flat fee per end
user with the revenue applied to the interstate requirement) for the
carrier common line charge.

(4) Modify the separations formula to reduce the share of NTS costs
assigned to the interstate jurisdiction. The change in allocation
would increase the revenue requirement of the intrastate jurisdiction.
The additional revenue requirement could be recovered through ordinary
local rate-making procedures as increases in either fixed monthly

charges or local usage charges.

The analysis of this paper suggests that options three and four
are the best long term solution to the pricing problem. Although it
may be possible to devise a better allocator of NTS than minutes of

use, no allocator will avoid distorting both consumer decisions and

- 59 -


investment decisions. Consequently, option one should only be viewed
a6 a temporary measure to solve urgent problems if it is pursued. The
use of regulatory tools to prevent entry requires restricting the
consumer’s freedom to use the telephone system in ways the consumer
sees as beneficial, and locks in the misallocation of resources that
occurs from wrong price signals. There is also serious doubt that
effective regulatory constraints could be devised that would protect
local telephone companies from the strong incentives to develop
competition. Option two would require a significant increase in
intrusive government regulation and might still be ineffective.
Options three and four are quite similar. Both effectively shift
the revenue requirement from a tax on long distance usage to an
increase in local charges. Both solve the bypass problem and increase
the efficiency of the telephone network. The difference is that option
three continues to treat the revenue requirement as an interstate
requirement and therefore requires federal determination of the method
of recovery while option four places a greater responsibility on the
States to determine the method of recovery. The economic effects of
the two options would be identical if the states chose to recover the
additional revenue requirement through an increase in the fixed local
charge per month for each access line. The choice between the two
options is largely dependent upon federalism arguments (such as the
relative weight to be placed on local determinations tailored to local

needs versus the federal interest in promoting interstate commerce)

- 60 -


ENFIA tariff charged a price far above the average cost of all business
lines for the line connecting a local office with the competitive long
distance carrier’s office. So long as MCI had no alternative for local
distribution, the ENFIA prices could be maintained. But although most
customers had no feasible alternative to using the local telephone
company to connect to a long distance carrier, the prices for ENFIA
lines were high enough to make it potentially profitable for MCI to
construct special facilities for access to the largest customers. This
was the origin of the bypass problem: prices for local lines providing
long distance access which are far above cost and high enough to make
private facilities less expensive for some customers. The bypass
incentives were weak at the time because of uncertainty over MCI‘s
future ability to provide ubiquitous service, and because the ENFIA
tariff was set lower than it would have been if the entire level of
AT&T’s payments to local companies had been included in the ENFIA

price.

The bypass possibilities inherent in the ENFIA tariff were greatly
magnified by the pricing adjustments associated with the separation of
the Bell Operating Companies from AT&T on January 1, 1984. The
previous flow of funds from long distance revenues to the local
companies paid by AT&T in settlements payments was converted into
access charges. The initial access charge for service between a

customer’s premises and AT&T’s Point of Presence was set at $.0845 per

- 16 -


Telephone Pricing to Promote Universal Service and Economic Freedom

Executive Summary

Competition and the divestiture have increased consumer freedom
to choose various kinds of telephone services and have corresponding ly
reduced the freedom of the telephone companies to price those services
in an arbitrary way. The interexchange carriers” ability to bypass
switched access services that provide a contribution to other telephone
services, together with the increasing opportunities in shared tenant
services, have indicated that the current pricing system may not be
sustainable. This paper explores the kind of pricing structure that
would be sustainable under highly competitive conditions. It finds
that price structures exist which raise the necessary revenue under
competitive conditions without creating any tendency to reduce the

present degree of universal service.

In the era of a unified network with carrier imposed restrictions
on the attachment privately supplied equipment to the public network, a
wide variety of prices could raise the revenue necessary to cover
costs. Individual customers had the choice of paying the specified
tariff, doing without service, building a private system, or seeking to
change the tariffs through the political process. Private systems were

viable in specialized cases (such as along a railroad right-of-way or




They are so commonly available that most consumers consider it their
"right" to have access to them. They are considered of great value
to consumers and those who do not have access to the public systems
will often incur substantial expense to build a substitute (such as
digging a well on rural property or building a private road to a remote
location). The savings in system cost from not serving a randomly
chosen consumer while still serving the surrounding consumers are very
small while the cost of serving one consumer in isolation from all
others is quite large. In other words, the cost of the system is not
simply the sum of the cost of serving each person. There is no well
defined cost of serving a single consumer without reference to what
other consumers are being served. Consequently, such systems cannot
be financed by simply charging each consumer the cost of service, but
must be financed by some kind of cost allocation scheme which spreads

the cost of the entire system over the actual or potential users of

the system.

A variety of cost allocation schemes are commonly used. Roads
are normally financed through a two part tariff. The fixed charge is
assessed to all property owners, whether or not they desire to use the
road, and is paid in the form of taxes, special assessments, or charges
to the builder when an area is developed. The usage charge 18 paid
in the form of a gasoline tax and thus is paid in proportion to usage

as measured by gasoline consumption. Sewer and water utilities are


together with the authorization of new common carriers to supply long
distance private lines, brought competition into the switched services
business. A call to MCI’s office over the ordinary local switched
network could be switched on MCI’s PBX to the appropriate private line
to teach the destination city, then connected back to the destination
telephone via an ordinary local call from the MCI office to the final
recipient. Such an arrangement could transform MCI‘s private line
facilities into the equivalent of a public switched network. MCI
packaged its entry into switched services as a “ghared private line

service" called Execunet.

The Execunet service threatened the viability of the then existing
price structure which passed substantial amounts of long distance toll
revenue back to local telephone companies. If a competitor could
originate and terminate long distance calls by paying only ordinary
business local rates, it could greatly undercut AT&T’s rates and still
remain profitable. After the Commission’s attempt to prohibit the
Execunet service was reversed by the Appeals Court, a compromise was
developed in which MCI was allowed to offer the service but required to
pay a much higher rate for local facilities used for long distance
access than for identical local facilities used for purely local calls.
The special tariff for long distance access (known as ENFIA) was an
explicit case of price discrimination according to use. Exactly the

same facilities were charged dramatically different rates depending on


2

the 1968 Carterfone decision2 and the 1969 MCI decision? . The MCI
decision allowed MCI to build an alternative common carrier microwave
system. Initially it was for the very limited purpose of a small scale
system im the St. Louis to Chicago market, but it formed the basis for
general authorization of competitive private line systems. The
Carterfone decision struck down restrictive carrier tariffs that
limited attachments to the network. Although its scope also was
initially limited, it led to freedom of choice to attach terminal
equipment to the network subject to minimal restrictions to prevent

harm.

The immediate effect of the Carterphone decision was to allow the
attachment of non-carrier-provided private branch exchanges (PBX‘s) to
the network. Because initial attachment was through carrier supplied
connecting arrangements, attachment of consumer telephones was then not
economically feasible. The change from treating PBXs as an integral
part of the network to treating them as a consumer item was extremely
significant. The PBX is a switching machine and can perform most of

the functions of a central office. Allowing private PBXs to be

Use of the Carterfone Device in Message Toll Telephone Service, 13 FCC

2d 420 (1968).

3

MCI, 18 FCC 2d 953 (1969), recon. denied, 21 FCC 2d 190 (1970).

-ll-


pnd,
¢ 4 Federal Communicatons Commission
C 3 Office of Plans ard Policy
g, & 1919 M Steet NW
yy £ Washington, OC 20554
USA

OPP Working Paper Series

1 s Telephone Pricing to
Promote Universal Service
and Economic Freedom

January 1986

Gerald W. Brock



remain in the core of the game even with an arbitrarily large number of

players.

An important characteristic of real world telecommunications
demand is the great variety in quantities of service demanded by the
various subscribers, and the correspondingly great variety in their
valuation of telephone service. An important question is whether or
not persons who value telephone service at less than the marginal cost
of serving them will ever be served under free market conditions. In
order to answer that question, assume that there is a wide variance in
consumer valuations of telephone service. Ignore the role of fixed
costs in real networks and assume that costs are completely determined
by a constant cost for each customer connected to the network plus a
constant cost for each unit of communication that flows over the

network.

Consider a numerical example. Suppose there are five potential
subscribers and usage is priced at its marginal cost. The company
wants to compute the set of access prices (not necessarily the same for
each person) that cover its total access costs while not allowing any
other company with the same costs to enter the market. The value to

any customer of communicating with any other customer (above the

- 34-


inducing customers to drop telephone service altogether.

The optimal price structure for a highly competitive industry
would probably offer a series of options, ranging from a very low fixed
charge with relatively high usage charges to a substantially higher
fixed charge with low or zero usage charges. There would be no
distinction between local calls for long distance access and other
local calls. In order to move toward such a structure and reach a
price structure compatible with both competition and universal service,
it 1s necessary to continue shifting the revenue requirement from long
distance to local service. The revenue shift can be accomplished in
two ways: (1) by retaining the existing separations formula but
increasing the subscriber line charge, or (2) by changing the
separations formula to reduce the revenue assigned to the interstate
jurisdiction. The economic effects of the two options would be
identical if the states chose to recover the additional revenue
requirement through an increase in the fixed local charge per month for

each access line.

In order to maximize opportunities for innovative use of the
telephone network, it is necessary to allow individuals a great deal of
freedom to construct alternative communications systems and to
interconnect them with the public network without discrimination. Any

attempt to solve the current bypasss problem or related problems of


demand, supply, and equilibrium conditions in the industry, the paper
reaches the following conclusions:

(1) With extensive competition but no regulatory limitations on price
discrimination, local companies can easily raise the necessary revenue
without driving people off the network simply by charging different
fixed prices to different customers in accordance with “value of
service" pricing.

(2) With extensive competition and limitations on price discrimination,
but no requirement to interconnect, local companies retain a great deal
of pricing freedom because competitive opportunities are limited by the
requirement to gain a large number of customers in order to make their
system useful.

(3) With extensive competition together with a regulatory requirement
to provide complete interconnection and to practice non-discriminatory
pricing, the local exchange companies” pricing freedom is greatly
restricted. Their ability to load costs onto fixed monthly fees is
limited by the possibility of drop-off by customers who value telephone
service at a low level and by the opportunities to arbitrage through
shared tenant services. The exchange companies’ ability to charge high
usage-based fees for access to interexchange carriers is limited by
the restrictions on price discrimination and by the opportunities for
bypass. However, they do retain a great deal of market power in the
local switched services segment and could raise whatever revenue was

necessary through increases in local measured service rates without


allocating costs among the participants. However, the combination of
the two requirements is very restrictive. It allows companies to avoid
the problems of setting up a complete self contained network and to
search for profitable niches in which a combination of new services and
resale of existing services can better the price offered by the
established firm for some customers. In the previous cases, a large
number of customers had to be attracted to the new network in order to
make it viable. In this case, it is only necessary to attract a few
customers whose requirements make the new offering seem more attractive

than the existing offering.

In order for a price structure to be sustainable with no barriers
to entry, no price discrimination, and required interconnection, there
must be no subset of products for which the total price of those
products is greater than the cost of producing them alone. That is a
very restrictive requirement in this case because the ability to
produce partial products and combine them with resale of products from
the established firm greatly reduces the cost of producing them alone
compared to the case where the potential entrant has to find a viable
independent system. Consider, for example, the price system defined by
charging for usage at marginal cost and charging each customer the
average remaining costs as an access fee. Such a scheme would produce
high allocative efficiency, but it might not be sustainable. A set

of tenants in a single building could combine their telephone demand

- 49 -


V. Equilibrium Conditions

The equilibrium price structure depends crucially on the degree
of price discrimination allowed and on the interconnection
requirements. If no limitations are placed on price discrimination
(so that persons receiving exactly the same service may be charged very
different prices), then the equilibrium price structure will attain
the maximum allocative efficiency and will achieve extremely high
penetration rates. However, under those conditions, there are many
possible distributions of the costs of the network, and some people
could pay very high prices. In the absence of regulation, these
conditions would allow the companies to exercise a great deal of market

power.

1f the companies are required to charge @ single price to all
customers, then interconnection conditions become crucial. With no
interconnection required, there remains a very large set of price
structures that cannot be undercut by free entry. This occurs because
the company’s pricing freedom is limited by the attractiveness of a
private network connecting only its own members. Because the value of
a network increases with the number of people attached to it, many
different price structures will meet the requirement for sustainability

if no interconnection occurs.

- 30 -


Company central office. All traffic in the building is consequently
aggregated as if it came from a single customer. The aggregation
increases the feasibility of bypass facilties, but it also limits the
fixed monthly charge per access line to the cost of providing an access
line substitute through a PBX and extension lines. Although the smart
building concept is currently limited to large business buildings, it
could conceivably be applied to apartment buildings or even residential
subdivisions if the fixed monthly access charges were high enough to

justify the substitution of a PBX and extension phones.

The possibility of bypass and smart buildings indicates that local
exchange companies do not have complete market power. Just as earlier
reductions in long distance monopoly power limited AT&T’s freedom to
choose a price structure, the current alternatives to local exchange
company service reduce the set of feasible price structures for
recovering a given revenue requirement. The remainder of this paper
explores the sources of exchange company monopoly power in an effort to
clarify the feasible price structures in an increasingly competitive

environment.

TI1. Demand Conditions

The demand for local telephone service is generally described

as demand for communication with anyone who can be reached on the

- 18 -


marginal usage charge) can be expressed in a value matrix as follows:15

1 2 3 4 5 Total Direct Value
1 0 40 30 20 10 100
2 40 o 15 10 5 70
3 30 15 0 5 3 53
4 20 10 5 ) 3 38
5 10 5 3 3 0 21

Indirect Value 100 70 #53 38) «(21

The matrix says that subscriber 1 receives an expected value of 40 from
communication with subscriber 2, an expected value of 30 from
communication with subscriber 3, and so forth for a total expected
value of 100 if all five people subscribe. The remaining people
receive lower expected values ranging down to subscriber 5 who receives

a total direct value of 21 if all subscribe.

15 The symmetry of this matrix is purely for computational convenience.
There is no reason why person A necessarily values communication with
person B at the same rate that person B values communication with person A.

-35-


minute, equivalent to over $500 per month per line for a heavy long
distance user with 100 hours per month per line. The price was high
enough to produce substantial incentives for large customers to either
build special facilities or to substitute private line facilities to
bypass local exchange company switched access service.) Although the
switched access price has now been reduced slightly to $.0795 per
minute, the price remains above the cost of alternatives for some
customers and thus attempts to extract more revenue from those

customers than the local exchange company’s market power can support.

While the possibility of bypass limits the revenue requirement
that can be loaded onto access usage charges, the possibility of "smart
buildings" limits the revenue requirement that can be loaded onto fixed
monthly access charges per line. With a smart building, individual
tenants subscribe to extension lines into the building PBX rather than

to local access lines providing direct connection with the telephone

5 For an estimate of the potential amount of bypass see Gerald Brock,
"Bypass of the Local Exchange: A Quantitative Assessment,” OPP Working
Paper # 12 (September 1984) NTIS # PB85 107811. Additional estimates with
different assumptions and methodology are contained in the Commission’s
bypass proceeding, comments filed in CC Docket 78-72 in response to Public
Notice 3206 (March 28, 1984) seeking bypass information.

-l7-


between local calls for long distance access and other local calls.
A long distance call would consist of two local calls (origination and
termination) plus the long distance company’s charge for service
between its offices.22 A series of such self selecting two-part tariffs
would be equivalent to a nonlinear revenue function with a low fixed
charge for access, relatively high usage charges for the first units of
usage, and volume discounts for larger amounts of usage. A special
discount for high volume two-point business (equivalent to current
private lines) would be necessary because of the ease of entry for such
business. Such a scheme could generate the same amount of revenue as
the current rate structure without reducing univeral service, without
generating incentives for uneconomic entry, and without creating

unnecessarily large amounts of allocative efficiency losses.23

22 This kind of non-discrimination between local calls which access
a long distance carrier and other local calls was what MCI originally
sought for its Execunet service.

23 The conclusion that a series of self selecting two-part tariffs can
provide an efficient way to recover the revenue requirement has been
extensively discussed in past literature. See, for example, Jerry Duvall,
"Telephone Rates and Rate Structures: A Regulatory Perspective," in A.
Baughcum and G. Faulhaber, Telecommunications Access & Public Policy
(Norwood, New Jersey: Ablex Publishing Corporation, 1984) which contains a
good discussion along with extensive references to related literature.



to link two corporate locations with a heavy communications demand
between them), but the absence of interconnection and economies of
scale in transmission equipment meant that private systems were not
an optimal choice for most customers. Consequently, practically any
tariff that charged customers no more than the value they placed on
telephone service was viable. Because many people place a very high
value on telephone service, the actual structure chosen was a function
of political control over rates, with benefits going to those who could
exert effective power in regulatory hearings. The total level of costs
determined the total level of revenues, but costs played only a minor

role an determining the rate structure.

The current limitations on carrier pricing freedom originate in
the interaction of the 1968 Carterfone decision and the 1969 MCL
decision. The Carterfone decision found AT&T’s restrictions on the
connection of customer supplied equipment to the public network
unlawful and resulted in customer freedom to use PBX’s and other
terminal equipment for any purpose the customer desired. The MCI
decision authorized MCI to build a common carrier microwave system for
supplying private lines. The decisions appeared quite distinct at the
time and were based on separate criteria related to the seemingly
distinct markets for terminal equipment and private lines. But a PBX
is a switching machine and can perform most of the functions of a

central office. Allowing private PBX’s to be attached to the network,


a set of players such that no subset of players can guarantee itself
a better payoff by withdrawing from the game. In the case of
telephones, the entire set is all subscribers to the public network and
any subset is a group of customers who might consider building a
private system to link themselves. Because of the benefits of being
able to reach a large number of customers, together with the economies
of scale of telephone equipment and restrictions on entry and resale of
circuits, the options of a group considering a private network were
extremely limited. Consequently, the prices were viable so long as no

group of customers was charged more than the value that group placed on

the services received.

Because many people placed a very high value on telephone service,
the constraint was very loose, allowing a wide range of feasible
telephone price structures. The actual structure chosen was a function
of political control over rates, with benefits going to those who could
exert effective power in regulatory hearings. The total level of costs
determined the total level of revenues, but costs played only a minor

role in determining the rate structure.

In the last twenty-five years, the protected market of the 1950
has been gradually exposed to competition. Each increase in

competition has reduced the set of viable prices. The first major


The idea that without interconnection a wide variety of prices
are sustainable against competition is consistent with the key role
that interconnection issues have played in the history of
telecommunications competition. Interconnection was a crucial
competitive weapon even in the original telegraph wars of the
mid-nineteenth century .18 Interconnection has remained a crucial
competitive issue in all phases of telephone competition ~- from the
original competitors after the expiration of the Bell patent to the
microwave authorizations for television transmission networks after
World War II to the disputes of the 1970°s over various forms of

interconnection for MCI and other new competitors.19 Even with the

subgroups that only call among themselves) increases the range of
sustainable prices. In simulation experiments with parameters
approximating actual telephone characteristics, simple two part tariffs
(an access charge plus a usage charge) were sustainable almost regardless
of the relative weight put on access or usage. If most costs were
recovered through an access charge, the low usage customers did not have
enough demand among themselves to benefit by a private system. If most
costs were recovered through a usage charge, the high usage customers could
not benefit from a private system because the gains from changing the price
structure were outweighed by the losses from being unable to call the low
usage customers.

18 For an excellent account of the development of telegraph companies
in the United States, see Robert L. Thompson, Wiring a Continent
(Princeton, N.J.: Princeton University Press, 1947).

19 These competitive issues are examined in detail in Gerald Brock,
The Telecommunications Industry: The Dynamics of Market Structure
(Cambridge: Harvard University Press, 1981).

-4@ -


sophisticated in avoiding the tax. A smaller tax on a broad base of
items is both less distorting of consumer decisions and harder to
avoid. Similarly, the current tax on long distance access provides
strong incentives to develop methods of bypassing the specific taxed
commodity of switched access to interexchange carriers, but a broad
based charge on all local usage would be both less distorting and

harder to avoid.

Several factors account for the lower distortion that would result
from spreading over all local calls the revenue requirement that is
currently raised by long distance access usage charges. The loss in
allocative efficiency from pricing above marginal cost is proportional
to the square of the distortion (the percentage by which price exceeds
marginal cost) multiplied by the elasticity of demand. Local service

has a lower price elasticity than long distance service.21 Spreading

21 Current estimates indicate that access elasticity is even lower than
the elasticity of local usage. Those estimates suggest that a fixed
customer line charge is more efficient than local measured service for
raising the revenue requirement. However, existing estimates do not take
into account the potential effect of shared tenant services, the externality
effect that a decision by some people not to subscribe reduces the value of
the network for remaining subscribers, or any special social welfare weight
to be attached to universal telephone service above any other commodity
people choose to purchase. If those factors are significant, then either
local usage charges or adjusted fixed charges (with reduced rates for people
most likely to drop off the system and for people most likely to switch to
shared tenant services) may be more efficient than a single fixed charge for

all subscribers.

- 54 -


for most telecommunications products (characterized by random demand
for service and low density between any two points), some kind of
network configuration which concentrates the demand for many two-point
communication paths through a small number of switches is the lowest
cost alternative.9 Because of the network nature of efficient
telecommunications facilities, there are strong economies of scope

among the various telecommunications products.10

9 The differences in minimum cost configuration are analogous to similar
differences according to location and density for transportation. In
railroads “unit trains" carry a commodity such as coal between two defined
points with a high volume traffic in that commodity, while lower volume
commodities are carried on cars which are switched and formed into new
trains as they make their way from origin to destination. Similarly, the
airline "hub and spoke" configuration provides a way of switching passengers
in order to provide lower costs than serving the same number of points with
direct flights.

10 Economies of scope exist over a given set of products when it is
cheaper to produce those products by a single firm than to produce them
by a set of specialized firms. The definition of a telecommunications
product as communication between two specific points at a given time means
that there are no demand externalities but there are strong economies of
scope because of the cost advantages of supplying many such products by the
same tirm. If the product is defined more conventionally as telephone
service trom a particular network, then there is only one product and there
are no economies of scope, but there are demand externalities. The
advantage of the narrow definition of the product for analyzing competitive
issues is that competitive possibilities do not occur uniformly for all
parts of the service provided by a network, but vary with the specific
characteristics of the product demanded. It is consequently necessary to
be able to distinguish demand arising from communications among various
customers within a building (subject to competition from "smart buildings")
from communications among widely scattered residential users (not subject
to competition at all at present) even though both may be receiving the
general product "telephone service" from the same network.

- 25 -


The costs of wiring a new neighborhood for telephone service are
dominated by the fixed cost of bringing a cable from the central office
to the neighborhood (a line of poles or underground trench) and the
construction costs of bringing the wires to the individual homes,
rather than the cost of the wire itself. The average cost of providing
telephone capability to a home when the entire neighborhood is being
wired is much lower than the cost would be to bring a special wire from
the central office to that home. Given the high probability that the
occupants of the home will want telephone service, it 1s cheaper to
plan as if telephone service will be universally desired than to
provide the physical facilities only when service is actually ordered.
Consequently feeder cables to individual neighborhoods generally
provide substantial excess capacity so that additional lines can be
utilized without adding to feeder cable capacity, and it is common to
bring the wires to homes and to provide inside wiring before knowing

whether or not individual occupants want telephone service. 11

ll For a discussion of typical wiring plans, see Bell Telephone

Laboratories, Engineering and Operations in the Bell System, and. ed.
(Indianapolis, Indiana: Western Electric Company, 1983), pp. 289-290.

- 26 =


have the customer discriminated againet unable to improve his situation
by forming a coalition with others. The reason is that for any
efficient network, rearranging the cost allocation is a pure income
transfer, but unanimous agreement is required in order to form a new
network with all participants. Consequently, those who are
disadvantaged by the income transfer will block the proposed new

network.

With no limits on price discrimination, the network can always
attain full allocative efficiency, regardless of the degree of
economies of scale or of the amount of fixed costs. Fixed costs can
be allocated as a flat service charge to those customers who place a
high value on telephone service. Consequently, usage charges for all
customers can be set at the marginal cost and access charges for
customers who place a low value on the network can be set below
marginal cost, while still covering all costs. This situation is
analogous to the public finance problem of raising a given tax revenue.
If lump sum taxes are allowed, then no pricing distortion results from
the tax. If the tax must be levied on any activity (sales, income,
etc.), then it always has some distorting effect and reduces allocative
efficiency. Similarly, if the fixed costs of the network can be
allocated in a lump sum to customers who will still accept the service,
they have no distorting effect. But if they must be spread. evenly

across customers in either access or usage charges, they will reduce

-41-


was overruled by the Appeals Court,4 the Commission endorsed a plan to
distinguish local service used for "interstate access” from identical
local service not used for such access through the the ENFIA (Exchange
Network Facilities for Interstate Access) tariff. The ENFIA lines used
for interstate access were ordinary business lines charged at a much
higher rate than other business lines in order to recoup some of the

subsidy for local service built into AT&T’s pricing structure.

The ENFIA tariff was a compromise between two competing
considerations. To allow Execunet as MCI proposed it would have
destroyed the viability of the entire switched long distance price
structure and would have required massive repricing of both long
distance and local services - all because of the unforseen consequences
of earlier decisions believed to be limited in scope. Yet to prohibit
MCI from offering the service was not a viable option because of the
appeals court rulings. With the ENFIA tariff, competition came to
switched service but the subsidy structure was preserved. Without the

ENFIA approach, either MCI would have been prohibited from entering

4 MCI Telecommunications Corp. v. FCC, 561 F.2d 365 (D.C. Cir. 1977),

cert. denied, 434 U.S. 1040 (1978) (Execunet I). MCI Telecommunicat ions
Corp. yv. FCC 580 F.2d 590 (D.C. Cir. 1978), cert denied, United States

Independent Tel. Assoc. v. MCI Telecommunications Corp., 439 U.S. 980 (1978)
(Execunet II).

~14-


as currently used in the telecommunications industry require the
companies to offer bundles of Similar but not identical Products, that
may have different cost characteristics, at the same price. For
example, there may be real cost savings from Connecting together a
large number of customers in the same building, compared to connect ing
the same number of customers Spread around a substantial area, but so
long as those are all the same class of customer (business or
residential) in the same service area, they are all charged at the same

rate.

The anti-discrimination assumption of this section does not limit
the company to simple linear prices. It may use any combination of
two part tariffs, volume discounts, and so forth but is required to
offer the same set of prices to all customers. The question to be
examined is: What range of price structures are sustainable against
entry when there are no barriers to entry? A price structure is
sustainable if there is no other price structure (with higher access
charges and lower usage charges, for example, or with higher prices for
low~volume users and lower prices for high-volume users) that would
cover the entrant’s costs if all customers who had an incentive to

switch to the new entrant did so.16

16 Ia more precise language, assume the existing firm specifies a revenue
function R(u) where u is the customer’s usage, R(u) is the total revenue

- 44 -


the burden over the much larger volume of local calls would greatly
reduce the percentage distortion. Both factors would reduce the total
loss in allocative efficiency. Spreading the burden over all local
calls would also greatly reduce the artificial incentives to bypass
the local telephone company because there would be no single group of

products with a high tax imposed on it.

In order to sustain an efficient open network with free entry,
it will be necessary to place greater reliance on local measured
service than is currently done. The traditional telephone price
structure (a fixed monthly charge for service, no usage charge for
local calls, and a substantial usage charge for calls outside the local
calling area) is becoming less viable because of technological change
as well as competition. The increasing use of computers on telephone
lines has resulted in some lines with usage far beyond the typical
level and has placed an increased load on switches and trunk lines.
The availability of electronic switching equipment, capable of low cost
usage measurement, has reduced the cost of charging for local usage.

Many companies have already established local measured service plans.

The optimal price structure for a highly competitive industry
would probably offer a series of options, ranging from a very low fixed
charge with relatively high usage charges to a substantially higher

fixed charge with low usage charges~ There would be no distinction

~55-




As the number of players increases, the core remains large because
existing subscribers benefit when one additional person joins the
network. However, the indirect benefits generated when an additional
Person joins the network are also computed as direct benefits for other
subscribers to the system. It is impossible to allocate to each person
the total benefits that person contributes to the system because such
an allocation would require twice the total benefits provided by the
System. In a costless symmetric system, each person’s direct and
indirect benefit to the system will be exactly twice the person’s
direct benefit and will be exactly twice the average payoff which can
be distributed. But there is nothing to require the benefits to be
distributed evenly. There are consequently a large number of very

different allocations of the total benefits to individual members that

box diagram in which two people participate in free trades, the core
solution consists of a range of values outlined by the points at which each
person is at the same utility level as he would be without trading.
However, in that case, as the number of traders increases, the core shrinks
toward a single point. In this case, the core does not shrink toward a
unique point, but remains large even with an arbitrarily large number of
traders. In the symmetric game with n players, the ratio of the maximum
payoff to the average payoff converges to 2 as n increases. The core is
a segment of an n-l dimensional hyperplane in n space, with the boundaries
of the hyperplane segment determined by the non~negativity conditions and
by the maximum payoff that an n-1 person coalition could guarantee for
itself.

-33-


If non-discrimination and interconnection are required, then the
price structure is greatly restricted. Competitive alternatives are
increased by the possibility of replacing a portion of the system and
connecting that portion with the remaining public system. Under these
conditions, it is still possible to develop sustainable prices, but
“the prices must be closely tied to the customer’s valuation of the

service and the cost of alternatives.

Case 1: No Limitations on Price Discrimination or Interconnect ion!3

Consider first a simple case in which two people consider
telephone communication between them. Each person values the
opportunity to call the other person at $1. A telephone system linking

the two people can be built at a price of $1, Will the system be

13 Although the ideas of this section are presented in a non-technical
manner with numerical examples, they are based on a well-developed
theoretical literature and could be put into a more general form with
formal proofs of the assertions. This section is based on the concept
of a transferable utility game, particularly as developed in W. W. Sharkey,
“Suggestions for a game-theoretic approach to public utility pricing and
cost allocation," Bell Journal of Economics, Vol. 13 (Spring, 1982):
57-68. The analysis drawe on the analytic framework of contestable markets
in which we imagine the possiblity of wholesale replacement of an existing
firm, putting aside real-world constraints of financing, personnel
policies, and fixed capital, in order to clarify the competitive
possibilities. See W. J. Baumol, J.C. Panzar, and R. D. Willig,
Contestable Markets and the Theory of Industry Structure (New York:
Harcourt Brace Jovanovich, Inc., 1982).

-31-


customers who have an average mix of local and long distance usage,
whether they are small users or large users. Compared to the present
situation, it would benefit customers with an above average ratio of
long distance to local usage and hurt customers with a below average
ratio. However, the present situation is not stable because of the
bypass incentives that exist. Consequently, even customers with a
below average ratio of long distance to local calling could benefit
from a change that generated the necessary revenue without creating

incentives for uneconomic bypass.

There is widespread recognition that the existing access plan is
unstable, and that it reduces long distance calling below the economic
level, encourages the substitution of private line access for switched
access even when switched access is cheaper to provide, and creates an
incentive for construction of expensive private facilities to provide
capacity that could be provided more cheaply over local exchange
company facilities. However, there is less agreement on the best
solution to these problems. Alternatives to the current access charge
plan can be classified into four general categories:

(1) Change the basis of allocating non traffic sensitive costs to long
distance carriers (currently computed from the relative minutes of
switched access usage) to some other basis that would produce the same
amount of revenue with less distortion. Proposed alternative

allocators include the number of equal access lines served by an

- 58 -


Telephone Pricing to Promote Universal Service and Economic Freedom

Universal

I. Introduction

The current structure of local telephone prices is unstable.
Two major revenue sources for local exchange companies are monthly
fixed charges per subscriber for telephone service and per minute usage
charges for access to the long distance carriers. The per minute usage
charges are threatened by bypass facilities in which the Jong distance
carriers or individual customers construct private facilities between
the customer location and the long distance company’s Point of Presence
(PoP) in order to avoid local exchange company charges- The monthly
fixed charges from some customers are threatened by the advent of smart
buildings in which @ building owner connects all users within the
building to a single PBX and passes the combined traffic to the local
exchange carrier a8 if it came from 4 single user, avoiding the monthly
fixed charges for the individual customers. Neither of these options
are available to nearly all customers at the present, but the
opportunities for profitable entry which they represent are an
indication that the current industry pricing structure is not in

equilibrium.


no common carrier type of requirement to serve and no requirement to
interconnect with other companies that may choose to enter the market.
Consequently, a new entrant must attract enough customers to have a
viable network without exchanging traffic with the established network.
A private microwave link used exclusively for communications among
offices of a single company would be viable entry under these
assumptions, but a "smart building" that concentrates traffic from a
building through a PBX would not be viable because that procedure

depends on connection with the existing network.

The significance of the non-discrimination requirement depends
upon the definition of the product. If the product is defined narrowly
as a communication path between specific points, then the
non-discrimination provision is of no significance because each
customer is located at a different point and is therefore ordering a
different service from any other customer. Consequently, any amount
of effective discrimination could be implemented by an appropriately
chosen price structure with different prices for communication

originating at each specific geographical location.

In this section and the next, assume that the non~discrimination
provisions must apply to telecommunications products as conventionally
defined; that is, to elements such as access, usage, bandwidth, and

total distance traveled. The standard anti-discrimination provisions

- 43 -


exist for the exchange of calls among a large number of points with
low volume on any particular two-point path. The access function is
subject to competition from local PBXs (that could conceivably link
up tenants in an apartment building, dormitory rooms in a college, or
even a residential neighborhood as well as the tenants in commercial
buildings). High volume two point demand can be served with private
facilities. But the large fixed costs of the public network are a
function of its ability to reach effectively all customers and that

ability is what must be charged for the fixed costs.

VI. Application to Current Policy Issues

The current issues related to this analysis include long distance
access charges, bypass, and smart buildings. Current long distance
access charges include a large usage sensitive charge, far above either
the cost of service or the price charged for similar local calls that
do not provide long distance access. The high usage charges provide
an artificial inducement to find alternatives that are privately
cheaper even though they may cost more than the telephone company’s
cost for the same service. The problem is compounded by the fact that
long distance access for large customers consists of a high density
two point circuit (from the customer to the long distance company Point
of Presence). Such high-density two point circuits are the form of

communication with the most alternatives.

-51-


telephone industry because of the complex cost and demand conditions.
True marginal costs for either access or usage for any individual
customer are very low. One person’s demand for telephone service is
dependent upon other people’s choice of whether or not to subscribe.
Under such conditions marginal cost pricing is neither economically

optimal nor capable of producing adequate revenue to cover total costs.

The special problems of telephone pricing have inspired an
extensive theoretical economic literature. This paper draws on that
literature for guidance in approaching the problem of finding a price
structure which allows free entry while retaining other desirable
policy characteristics. The paper first examines the origin of current
pricing problems. It then reviews the supply and demand
characteristics of telephones and derives the equilibrium conditions
that result. The crucial role of interconnection conditions and the
allowable degree of price discimination in determining the equilibrium
allocations is stressed. With the same cost and demand conditions,
very different equilibria occur with no limitations on the companies
than occur with required interconnection and limitations on
discrimination among customers. The paper concludes that prices exist
that will sustain the network even with free entry, required
interconnection, limitations on price discrimination, and a continuing
obligation to serve all customers. Furthermore, such prices will

encourage effectively universal service and lead to a high degree of


Il.

Ill.

IV.

VI.

vil.

LE OF CONTENTS

Executive Summary

Introduction

The Origin of Current Pricing Problems

Demand Conditions

Supply Conditions

Equilibrium Conditions

Case 1: No Limitations on Price Discrimination
or Interconnection

Case 2: No Discrimination Limitations but
Interconnection Required

Case 3: Price Discrimination Prohibited,
Interconnection not Required

Case 4: Non-Discriminatory Pricing, Full Interconnection,
and Obligation to Serve

Application to Current Policy Issues

Conclusion

18
24
30

31
42
42
48
51

61


IV. Supply Condit ions8

There is no single product of "telephone service" with
identifiable cost characteristics. Instead there are a vast number
of products of the form "a communications path of a particular
bandwidth and other technical characteristics between points A and B
beginning at time x and extending for y minutes." The cost of
providing the products varies with the technical characteristics
required, the specific points requiring service, and the time

distribution of the service requirements.

There are many potential technologies and network topologies for
supplying the demand for telecommunications services. For some
products (high volume continuous demand between two reasonably close
points with line-of-sight access), a dedicated facility such as a

private microwave facility may be the lowest cost configuration. But

8 There 1s a great deal of uncertainty about the current cost conditions
in the industry and even more uncertainty about the cost structure of the
future telecommunications industry. The purpose of this section is not to
present an empirical analysis of current costs or an estimate of future
costs. Instead, this section attempts to clarify the general torm of the
cost structure to the degree that the cost structure is relevant to the
theoretical analysis of this paper. The statements in this section could be
considered “stylized facts" structured to clarify the pricing problems of
telecommunications. Such "stylized facts" substitute an easily
comprehensible general structure for the complex detail of a full empirical
study.

- 24-


attached to the network was essentially a decision to allow a private
switched communications system to be attached to the network. This
had far greater implications than was realized at the time. The
debates over PBX interconnection revolved primarily around network harm
and secondarily around the economic effects of PBX competition on
carrier finances. But the economic discussion was concerned with
revenue from PBX“s alone, not with potential changes in the price
structure of other services that would be caused by the use of

privately owned PBX’s,

The immediate effect of the MCI decision was to limit the prices
that could be charged on the dense private line routes most subject
to competition. It expanded the set of customers affected by the
private microwave decision from those with internally dense
communications needs to all those whose private line requirements were
on routes with total demand high. Consequently, a further price
restructuring occurred with the Hi-Lo and MPL tariffs. Those tariffs
offered lower prices for high density routes than for low density
routes, and also offered lower prices for long distance routes and
higher prices for short distance routes than before. As with the
Telpak tariff, the new tariffs reallocated some of the fixed cost
burden from customers who gained an additional alternative by the new
authorization to those who still had no other alternative after the new

authorization.

-12-


The FCC OF

f Plans and Policy's Working Paper Series presents
staff analysis and research in various states. These papers are intended to
stimulate discussion and critical comment within the FCC, as well as outside
the agency, on issues in telecommunications policy. Titles may include
preliminary work and progress reports, as well as completed research. The
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and do not necessarily reflect the views of other members of the Office of
Plans and Policy, other Commission staff, or the Commission itself. Given the
preliminary character of some titles, it is advisable to check with authors
before quoting or referencing these Working Paper in other publications.

Copies may be purchased from the International Transcription Services, Inc.,
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Assume that access cost is a constant 40 per person and consider
Potential equilibrium pricing combinations. The most obvious price
is the cost~based non-discriminatory price of 40 per person. At that
price the first three people will subscribe. Person 1 receives an
expected value of 70 and pays 40 for access, leaving net consumer
surplus of 30. Person 2 receives an expected value of 55 and a net
consumer surplus of 15. Person 3 receives an expected value of 45 and
a net consumer surplus of 5. Persons 4 and 5 value the network less

than the access fee of 40 and both decline subscription.

Now consider the effect of potential entrants with access to the
same technology. In order to attract customers, the potential entrant
must make them better off than with the current network; that is, the
Potential entrant must improve upon the consumer surplus vector of (30,
15, 5, 0, 0). One possible way to do that is to offer person 4 an
access price of 30, leaving a deficit of 10 from the marginal cost of
40. However, adding person 4 to the network makes person 1 better off
by 20, person 2 better off by 10, and person 3 better off by 5. Any
distribution of the 10 unit deficit among the first three persons that
costs each of them less than the benefit to them of having person 4
on the network will cause them to join the new competitor. Suppose,
for example, a competitor offers an access price vector of (50, 40,
40, 30, 30). This will result in a 4~person network and a net consumer

surplus vector of (40, 25, 10, 5, 0) that improves all four subscribers

- 36 -


on certain events, but they can be expressed in terms of willingness to

pay for the option to make calls.

The definition of telephone demand in terms of underlying
individual demand curves is not a mere terminological quibble, but is
important to understanding the equilibrium pricing conditions in
telecommunications. The costs of communications among various sets
of customers vary. For example, it costs less to provide
communications among a compact set of customers who are all in one
office pbuilding than to provide the same amount of communication to
the same number of customers spread all around a city. Similarly it
costs less to provide a high volume of communications from one customer
to one other customer than to provide that same volume of
communications from one customer to a large number of other customers.
These cost distinctions are lost when the telephone product is defined
in terms of access to the network plus usage of the network. In order
to evaluate the effect of competition on existing networks, it is
necessary to explicitly consider the underlying demand elements and
the costs of supplying those elements by both the established company

and by potential competitors.
The standard definition of telephone service (access to the

network plus usage) is based on established pricing patterns. Those

pricing patterns are practical solutions to the problem of pricing a

- 20 -


obligation to serve causes it normally to maintain enough excess
capacity to reconnect any dwellings in its service area.
Consequently, discontinuance of service once it has been established
provides practically no cost savings. Insofar as the marginal costs
of access can be defined, they are caused by the first occupant of
the dwelling who orders service. The decision of subsequent occupants
to order or not to order service makes very little difference to

telephone company costs.

The distinctions among various kinds of marginal costs are
important because they determine a telephone company’s incentive to
induce potential customers who place a low value on telephone service
to subscribe. If the marginal cost of providing access to those
customers is the average non-traffic sensitive plant per customer (as
is often assumed in discussions of cost-based telephone pricing), then
the telephone company has no market incentive to retain marginal
customers on the network. But if the cost savings from having a
customer discontinue service are very small, as is suggested by this
analysis, then under competition the telephone companies have an
incentive to design price structures that retain practically all of

their potential customers on the network.

- 29 -


the long distance market or the subsidy structure would have been
competed away. The ENFIA tariff was an explicit discrimination
according to use. It was consequently a movement away from the general
trend of allowing consumers to use any given service provided by the
telephone company in any way the consumer chose. With ENFIA, exact ly
the same facilities were charged at dramatically different rates

depending on the purpose for which they were used.

The ENFIA tariff illustrates the power of price discrimination
for maintaining a given price structure in the presence of competition.
The natural implication of the ability to combine a privately owned PBX
with free entry into private line service was that the long distance
contribution to local costs would have been eliminated, just as the
earlier decisions had changed the contribution of various classes of
private line users. But with the ability to distinguish interstate
access from other local calls and to charge a higher price for
interstate access, the price structure could be maintained even in the

presence of competition.

Although the ENFIA tariff was successful in meeting the immediate
goals of allowing some competition in switched service without
destroying the existing flow of funds from long distance to local
service, its viability was dependent upon the local exchange

companies” possession of monopoly power in local distribution. The

- 15-


potentially uneconomic entry through entry prohibitions will create
artificial walls around certain services and reduce the possibilities
for innovative use of the telephone network. But a policy of open
entry together with price structure reform will lead to maximum
consumer freedom together with economic efficiency and protection of

universal service.


The problem of generating the revenue to pay the fixed costs of
the network is formally the same as the problem of designing a good tax
structure to generate a fixed amount of revenue. The current access
charge structure is analogous ‘to a decision to generate the entire
sales tax revenue for a city from a tax on a single item. Suppose,
for example, that a city decides that it will generate all of its sales
tax revenue from a large sales tax on bread and save the effort of
taxing every purchase. Such a tax would induce a great deal of effort
to avoid it - home baking of bread, providing close substitutes for
bread which can avoid the technical definition of the taxed commodity,
and simply switching to other foods. It is certain that the bread tax
would raise substantially less revenue than a simple multiplication of
the tax rate times pre-tax sales would indicate. Furthermore, the

revenues would probably decline over time as the population became more

interstate non traffic sensitive revenue requirement were converted into
fixed end user charges, it would be unlikely to induce a large increase in
shared tenant services (sTS). But technological progress in PBXs and
changes in the regulatory structure could make STS a more significant
constraint in the future. Even though STS is not an important current
constraint on pricing, it is an important factor for evaluating the long
run pricing structure of the industry because it provides a substitute for
the local line. If STS costs decline, the local access line cannot be
treated as an inelastic commodity to which all residual costs can be
assigned. Instead, the local lines will have to be priced with regard to
the opportunities for STS, and any residual revenue requirement made up
from usage charges.

-53-


compared to the earlier consumer surplus vector.

The second price vector is an unambiguous improvement over the
first, but it is still not a sustainable equilibrium. Consider another
entrant that offers a price of 20 to person 5 and distributes the the
deficit of 20 over the other subscribers. There is less freedom in
this choice because the total indirect benefit of person 5 is only 21.
The requirement that each person remain at least as well off as before
almost determines the distribution. One possibility is to offer an
access price vector of (59.75, 44.75, 42.75, 32.75, 20). This
distribution provides the required 200 of revenue to cover the 200 in
access cost and leaves a net consumer surplus vector of (40.25, 25.25,
10.25, 5.25, 1). All five participants find the new consumer suplus
vector superior to the previous one and would consequently join the

new proposed system.

Although the price vector discriminates among customers, charging
person 1 a price of 59.75 for precisely the same service for which
person 5 is charged 20, it is sustainable against new entry. If all
demands were independent, as is normally assumed in economic analysis,
and if the costs were linear as assumed here, then a new entrant would
serve only the three people who value the service above the marginal
cost of serving them. However, in this case, serving only those three

people does not make them better off because they gain enough

-37 -


The degree of pricing freedom is dependent upon the customer’s
total valuation and the historical situation. If no telephone network
exists, there is a great deal of freedom to allocate benefits among
the high value customers. The example above used net consumer surplus
in proportion to the customer’s total valuation, but that is not
necessary. It would be possible to devise sustainable prices that give
more consumer surplus to person 2 than to person 1. The only
constraint is that the maximum distribution to a person or group is
the amount that leaves the remaining customers with the same benefit as
they could obtain by forming a network excluding the person or group
receiving maximum benefits. But within wide ranges, any price which
brings a1] the viable subscribers onto the network will be sustainable,
regardless of the actual distribution of consumer surplus which
results. However, once a distribution has been developed, it
constrains the future distributions because any entrant must match the
welfare of each person in order to induce that person to switch. If
the intial firm priced to give an "unfair" amount of consumer surplus
to person 2, a new entrant must also do that in order to get person 2
to switch. Thus pricing patterns established in a somewhat random way

could be continued by the process of successive entrants.
There is less pricing freedom for persons near the margin than for

those who value the network far above the marginal cost of serving

them. The marginal customers must be given low enough prices to induce

- 39 -


The current situation in which profitable niches exist for
entrepreneurs has occurred several times since the beginning of
competition for telecommunications. In each case a plausible case
could be made that the profitable opportunity resulted from the
specific way in which fixed costs were loaded onto the prices of
individual products, rather than from the superior efficiency of the
potential entrants. The established firms have regularly argued for
restrictions on entry in order to prevent “cream-skimming" and
destruction of established pricing patterns, while the potential
entrants have argued for freedom to apply their talents to any
opportunity they choose. The Commission has frequently ruled in favor
of economic freedom rather than preservation of established pricing
patterns, and thus has gradually introduced competition into the

industry with resulting changes in the price structure.

As the competitive possibilities in local telephone service have
unfolded, the question of whether or not legal restrictions on entry
are needed in order to preserve the ability of the local companies to
provide effectively universal service has again been raised. This
paper examines the price structure necessary in order to allow freedom
of entry without encouraging entry by inefficient competitors.
Determining a sustainable price structure is not a simple task. Simple

formulas such as “adjust prices to cost" are inapplicable in the local