-16-

Regulatory handicapping works in similar fashion. If one firm is forced
to bear higher costs than others (e.g., through differential "loading" of
fixed costs) or is forced to meet regulatory requirements that put it at a
competitive disadvantage vis a vis its rivals, it may lose market share and
its rivals may gain share. ‘These changes are again of limited significance
since they reflect the effects of regulation rather than canpetitive
performance. They do verify the ability of competitors to enter and
successfully exploit market opportunities presented by inefficient pricing.

It is, of course, perfectly legitimate to argue that entrants would have
entered and prospered without asymmetric regulation, but the point is that
that cannot really be known or is at least less convincingly known in the
presence of such regulation. Baumol et. al. (1982, p. 351) define an industry
to be a natural monopoly if the cost-minimizing industry structure is a single
firm. Competition provides the market test of whether a monopoly enterprise
is actually a natural monopoly--Can it succeed in remaining alone in an open
market? If competition is restricted, there can be no such test. Thus, a 100
percent share is of little probative significance if entry is blockaded.
Similarly, an industry with a “competitive” structure may not be all that
competitive if competition had little to do with the determination of that
structure and regulation had a lot to do with it. Replacing a regulated
monopoly with a regulatory cartel would place the telephone industry
approximately where the airline industry was prior to deregulation.

Regulatory attempts to create a “preferred” market structure spoil the

market test. Econanic history suggests they are unnecessary and regulatory


37-

discrimination is designed to maximize profits
regardless of output consequences.

Multipart tariff proposals that result in increased contribution to overhead
cost recovery improve the econanic welfare of all consumers, not just those
who take advantage of “the price cuts. That suggests the wisdom of adopting an
increased contribution standard for judging whether such tariffs serve the

public interest.


-33-

In OPP Working Paper #8, Daniel Kelly (1982) suggests that telecanmmnications

markets may exhibit characteristics that make predatory behavior profitable,
but that divestiture solves most of these problems. ‘The MFJ stripped AT&T of
its protected position‘ by vesting control of the Bell System's local exchange
("bottleneck") facilities with the new regional holding campanies. In his
recent decision sustaining the FCC's imposition of separate subsidiary
requirements on the BOC's, 46/ Circuit Judge Richard Posner found that:

The basic source of AT&T's monopoly power was not the

manufacture of telecamminications equipment or even the

ownership of the nation's long-distance lines; it was

the operating campanies' control of access to the
telecammunications network. ‘The inheritors of the Bell

monopoly are the operating companies rather than AT&T.

Kelly recammends that transitional deregulatory measures identify the
potential for anticampetitive conduct and take steps to limit such behavior if
the benefits exceed the costs. Given AT&T's desire to be freed fran
regulation, it would appear to lack incentive to engage in predatory
behavior. Indeed, it has a strong interest in avoiding predatory behavior.
This view is shared by William McGowan, Chairman of MCI. In a recent New York
Times interview (12 Feb 84), he is quoted as saying that:

There's roan for a lot of people in this business.

There's roan for them. There's roam for us. No one is
caning in with the idea of losing money.

—_———

46/ See Illinois Bell Telephone cope et. al. v. FCC, Nos. 84-1145,
84-1382, 64-1475, slip opinion at ith Circuit, June 29, 1984).


-10-

In terms of telecammnications cost studies, specifically, Phillips
(1982, p. 11), a close student of the industry who believes there is
compelling evidence of cost subadditivity, nevertheless disclaims that:

Econametric tests are, of course, frought with technical
difficulties. It is indeed questionable whether matters

* of so grave a concern as the structure of the telecammnications
industry should be based on them alone.

According to D.S. Evans and J.J. Heckman (1983, p. 149):

[Nlone of these studies can provide decisive evidence
that the telephone industry is or is not a natural
monopoly. The most reasonable conclusion that can be
made fran the available evidence on the cost
characteristics of the telephone industry is that there
is weak evidence that this industry is not a natural
monopoly. (emphasis added)

These authors subsequently note the possibility that “more sophisticated
studies with better data may reverse our finding that the telephone industry
is not a natural monopoly or may find that particular telephone services can
be provided most efficiently by a single firm."

The third difficulty with econametric authentication arises because
actual estimates conflict. Thus, even if one were willing to rely upon this
method of authentication, there would still be a problem because there is no
consensus in the literature about the answer to the question at issue.
Compare Phillips’ summation of what the evidence shows with Evans and
Heckman's.

Phillips (1982, p. 11):

Numerous examinations of AT&T's and Bell Canada’s

operating costs are virtually uniform in rejecting the
esis of constant returns to scale. The more

sophisticated of these explain observed costs in tems

of output rates for several telecammnications services

[i.e., they test for econamies of scope], factor and
materials input prices, and one or more proxy variables


-20-

problems to be solved by the process of canpetition." 27/ It is only through
the process of campetition that these facts will be discovered.
In his famous essay on “The Use of Knowledge in Society," Hayek (1948A,

p. 77) explains that:

: If we possess all the relevant infomation, if we can start
out from a given system of preferences, and if we command
canplete knowledge of available means, the problem which
remains is purely one of logic. That is, the answer to the
question of what is the best use of the available means is
implicit in our assumptions...This, however, is emphatically
not the econanic problem which society faces...The econanic
problem of society is not merely a problem of how to allocate
“given” resources--if "given" is taken to mean given to a
single mind which deliberately solves the problem set by these
“data." It is rather a problem of how to secure the best use
of resources known to any of the members of society, for ends
whose relative importance only these individuals know. Or, to
put it briefly, it is a problem of the utilization of
knowledge which is not given to anyone in its totality.
(emphasis in original)

It clearly makes little sense to evaluate the econamic organization of an
industry on the basis of how well it comports with a theoretical ideal, which
is ideal only in terms of solving a problem different fram the one we actually
face and are really interested in solving.

A related but distinct line of criticism is that of Joseph Schumpeter,
who argues that, in the long run, it is product rather than price competition

(narrowly construed) that is of primary importance for expanding consumer

27/ See Hayek (1948B, p. 96).


-38-

LIST OF REFERENCES

Allen, Willian, “Antitrust Policy and the Competitive Model," Midnight
Econamist: Broadcast Essays IV (July 1982).

Bailey, Elizabeth, David Grahan amd Daniel Kaplan, Deregulating the Airlines
(1984). é

Baumol, William. “Quasi Permanence of Price Reduction: A Policy for
Prevention of Predatory Pricing," Yale Law Journal (November 1979).

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

Becker, Gary, Economic Theory (1971).

Brozen, Yale, Concentration, Mergers and Public Policy (1982).

Demsetz, Harold, “Two Systems of Belief About Monopoly," in Industrial
Concentration: The New Learning, Harvey Goldschmid et. al. (eds.)

(1974).
, “Barriers to Entry,” American Econanic Review (March 1982).
Evans, D.S. and J.J. Heckman, “Natural Monopoly," in Breaking Up Bell,

David Evans (ed.) (1983).

Faulhaber, Gerald, “Cross-Subsidization: Pricing in Public Enterprises,”
American Economic Review (December 1975).

FCC, In the Matter of Long-Run Regulation of AT&T's Basic Domestic Interstate
Services, CC Docket No. 83-1147.

Friedman, Milton, Capitalism and Freedan (1962).

. “The Methodology of Positive Economics," in Peadings in
Microeconanics, Willian Breit and Harold Hochman (eds.) (1971).

Griffin, James, “The Welfare Implications of Externalities and Price
Elasticities for Telecanmunications Pricing," Review of Econanics and
Statistics (February 1982).

Hayek, Friedrich, Te Use of Knowledge in Society" and “The Meaning of
Competition" in Individualism and Economic Order (1948 A and B).

, “Competition as a Discovery Procedure,” in New Studies

——————

(1978).
Kahn, Alfred, The Economics of Regulation (II) (1971).

, “The Uneasy Marriage of Regulation and Campetition *
Telematics (September 1984).



I. Introduction

There is general support for the idea that natural monopoly markets
should be regulated if there are methods of regulation capable of generating
net benefits (i.e., as long as the cure is not worse than the disease) and
that effectively competitive markets should not be regulated since the
benefits of regulating a campetitive market to prevent monopoly abuse are zero
and the costs are not (i.e., if it ain't broke, don't fix it). 1/ This leaves
a critical question unanswered: How does one determine whether or the extent

to which a market is campetitive or monopolistic?

—_——

1/ Opinion about the efficacy of regulation varies considerably. Oliver

Williamson (1976, p. 73) observes that:
The orthodox attitude among econamists toward regulation
is one of "disdain and contempt." The general
reputation is not undeserved...

Milton Friedman (1962, pp- 128-129) states that:
There is unfortunately no good solution for technical
monopoly. There is only a choice among three evils:
private unregulated monopoly, private monopoly regulated
by the state, and government operation... ~{T]he great
disadvantage of either goverrmental regulation or
governmental operation of monopoly is that it is
exceedingly difficult to reverse. In consequence, I am
inclined to urge that the least of the evils is private
unregulated monopoly wherever this is tolerable.
Dynamic changes are highly likely to undermine it and
there is at least same chance that these will be allowed
to have their effect. And even in the short run, there
is generally a wider range of substitutes than there
seems to be at first blush, s0 private enterprises are
fairly narrowly limited in the extent to which it is
profitable to keep prices above cost. Moreover, the
regulatory agencies often tend themselves to fall under
the control of the producers and so prices may not be
any lower with regulation than without regulation.


31-

selectively rather than by raising them selectively. Downward deaveraging,
like downward pricing flexibility, leaves no one worse off relative to their
current position.

A zone of reasonableness with no upward pricing flexibility would also

discourage predatory pricing, the topic to which we now turn.

C. Downward Pricing Flexibility and the Question of Predation: When

there is a nontrivial probability that natural monopoly elements are
important, standards of fair competition assume special significance because
of the possibility that firms may fail naturally as a result of effective
canpetition rather than unnaturally as a result of unfair exclusionary
behavior. 43/ Optimal standards of fair pricing should seek to balance the
costs of two different types of errors--costs associated with reductions in
competition resulting fran a failure to discern predation when it is really
occurring and costs associated with reductions in canpetition resulting fran a
finding of predation when it is not really occurring. The costs of Type I

errors are the higher prices that result because campetitors have been driven

43/ Gary Becker (1971, p. 95) notes that:
For at least the last 200 years, econamists have been
trying to understand why some industries are campetitive
and others monopolistic. And for almost an equally long
period, two competing explanations have been offered:
one stresses the technological conditions that make
monopoly inevitable, the other stresses the incentives
to collude and suppress campetition.


-17-

history suggests they are likely to be costly and ill conceived. 22/ The merger .

movement in the 1890's and the subsequent experience of the resulting

consolidations have several lessons to offer to proponents of regulatory market

share management. Most of the large mergers of that era consolidated more than

50 percent of the capacity in their respective industries into a single firm.
George Stigler (1968, p- 102) reports that:

.e. {T]he mean share of the market controlled by the
mergers studied by the Industrial Commission was 71
percent (one in the 25 to 50 percent range, 11 in the 50
to 75 percent ri , and 10 in the 75 to 100 percent
range). In the ninety-two large mergers studied by
Moody, the distribution by share of market was

similar: seventy-eight controlled 50 percent or more of
the output of the industry; fifty-seven controlled 60
percent or more; and twenty-six controlled 80 percent Or
more.

Yale Brozen (1982) has studied the perishability of the market shares of
these dominant firms. He (1982, P+ 217 and p. 219) concludes that:

Turn-of-the-century canbinations were often created in
order to monopolize and, less often, to econamize and
improve service to customers. Where managements tried
to use daninant positions to extract supracanpetitive
prices, however, the consolidations did not long remain
dominant or viable. Only where they quickly gave up

monopolizing and price-raising activities and turned

their attention to improving efficiency,

_—_

22/ John Meyer et. al. (1980, Pe 184) note that:
The concept of “regulation creating a better market
structure” relies, at its base, on the assumption that
regulation has the capability to modify and create the
market structure it seeks. This inevitably raises the
tion of whether regulation can, in the long run,
really modify market structure in important wayS.

For an economic critique of FCC attempts to create a preferred industry
structure in broadcasting, see R. Noll et» al. (1973).


-23-

we knew we had a natural monopoly (which we do not know) and if a natural
monopoly had adequate incentives to innovate (which it may not, given
effective profit regulation) and if a regulated monopoly could be relied upon
to price efficiently (which historically it did not), then regulated (and in
seme cases closed) monopoly would be more efficient than alternative modes of
organization.

Econamists have shown that in certain cases costs can be subadditive
(i.e., an industry can actually be a natural monopoly) + but there may
nevertheless be no set of prices sustainable against entry. 32/ Phillips
(1982, Pp- 22-23) concludes that “where prices are not sustainable... .barriers to
entry must be included within the regulatory set." 33/ For unsustainability to
justify restraints upon economic freedom, empirical estimates of cost
parameters showing that ‘possible’ ciramstances are ‘actual’ circumstances
are necessary- If such a demonstration is virtually impossible given
impossible-to-fulfill data requirements, the limited power of existing
econometric tools, the nature of governmental processes of authentication and,
in particular, the potential for obfuscatory exploitation of canplexity
abounding therein, unsustainable natural monopoly can never succeed as a
policy rationale.

Without empirical support, the unsustainable natural monopoly rationale

for entry restrictions assumes the quality of religious argument for it

ee

32/ See Baumol et__al- (1982, DP» 221-224).

33/ Ina recent papers Richard zerbe (1984) proffers the same advice.


-19-

tool of analysis. It defines a type of market equilibrium that provides a

basis for predicting the effects of changes in supply and demand in

comparative static terms. 25/
There are other purposes for which this type of model is unsuited and,

therefore, inadequate ‘for purposes of explanation and understanding. 26/ One
such is the idea that it provides useful benchmarks against which real markets

can be campared to gauge their “competitiveness.” As William Allen (1982, P-

43) observes:

{T]here are fatal difficulties in using abstract
conceptualization of a never-never world of atomistic,

equilibrated uniformity as 4 guide in grading and possibly
circumventing and constraining the ever-evolving, adjusting

real world--a world of risk and uncertainty experimentation
and research, disequilibrium and change, sweat and strain. In
such a world, it is naive to suppose that we have available a
simple neat measuring rod of market behavior and influence,
enabling us readily to identify the bad and the beautiful,
distinguishing “monopolists” fran “campetitors."

The basic shortcaning of the theory of perfect canpetition as a theory of

rivalry or canpetitive process (as opposed to market equilibrium) is that it

assumes what it should explain. The productive capabilities of producers
(including their ability to persuade consumers to buy what they are trying to
sell) and the wishes and desires of consumers (including what kinds of
products and services they want to buy and how much they are willing to pay)

“cannot properly be regarded as given facts but ought rather to be regarded as

_
(25/ See Paul Samuelson (1947).

26/ On the importance of appropriate mode] selection for competition policy
analysis, see Richard Schmalensee (1979).


-32-

fran the market. The costs of Type II errors are the higher prices that
result because canpetitive rivalry has been stifled. 44/

In modern econamic analysis the success of a predatory strategy is
posited to depend on the credibility of the predator's threat to rivals.
Because predatory pricing does not, in general, pose a credible threat in
strategic terms, most econanists reject predatory pricing as a likely
exclusionary strategy. 45/ It has been suggested that a predatory pricing
threat may be more credible if the would-be predator operates fram a protected
monopoly position for that may provide a means for offsetting losses incurred
fran below-cost pricing. If a firm lacks such a protected position, it is
logically precluded from using it to acquire or sustain other monopoly

positions.

44/ In his exchange with Professors Areeda and Turner on predatory pricing
policy, F.M. Scherer (1976, D. 874 and p. 902) supplies these illustrative
warnings:

I can think of no surer way to encourage passive

noncanpetitive behavior on the part of firms with market

power than to adopt a rule leaving open only those

responses to new entry that are ineffective or self-

defeating. A “deterrer challenged mst yield" rule

would undoubtedly engender repetitions (for different

reasons, to be sure) of the Canadian cement industry

experience, where passivity by the dominant firm in the

face of new entry lead to a 55 percent capacity

utilization rate during the late 1960's.

«..67 years of sluggishness, as in the American steel
industry would be an appalling price to pay for a policy
that encouraged passivity by the daninant firm...The
United States Steel Corporation was organized in 1901
but did not begin defending its position with noticeable
vigor until 1968.

45/ See, for example, John S. McGee (1980), Roland Koller IT (1971) and
Richard Posner (1976).


-14-

A more fundamental criticism of the market share approach is that it
infers ineffective campetition on the basis of a measure that may in fact
reflect effectively competitive behavior. As Landis and Posner (1981, P- 976)
note:

* The firm that by dint of cutting costs and price obtains
a large market share should not be condemned as an
unlawful monopolist. It should always be open to a
defendant in an antitrust case to rebut an inference of

market power based on market share by showing that its
market share is the result of low prices.

In modern econamic analysis, focus has shifted fran the number of actual
competitors in a market as a determinant of industry performance to conditions
of entry and the presence (or absence) of size econanies as determinants of
industry structure. 19/ Relationships between industry structure, firm
behavior and performance are reciprocal, but modern analysis suggests that
absent unwarranted barriers to competition, industries will tend to be
structured in the manner that maximizes efficiency. In the absence of
protection from competition, large firm size is not a demerit but should be
taken as evidence of efficiency. Firms that do a good job satisfying consumer
preferences tend to grow and become large or, in more value-laden terminology,
“dominant ."

In unregulated markets, the econanic meaning of a large market share is
ambiguous. A large market share may imply the presence of monopoly power.
Alternatively, a large market share may reflect provision of good service,
indicating effectively competitive behavior and no problem of monopoly. in
regulated markets, the significance of market share as a measure of either

EE

19/ See Harold Demsetz (1974) and M. gmirlock et. al. (1984)-


single firm, that firm may possess monopoly power- 8/ Regulation may then be
imposed as a means of preventing exploitation of market powery while simultaneously
obtaining the cost savings associated with single-firm organization.

That, of course, is an idealized portrayal of regulation. Actual
regulation shares the “erait of imperfection with all other other real econanic
institutions. In particulary the idea that regulation is needed to prevent
the prices of long-distance telephone services fran exceeding their econamic
costs ignores that, historically, regulation has been an important reason why

prices have exceeded costs. 9/ The view that regulation and competition are

_

8/ Market power depends on the absence of close substitute product S+

9/ AS John Wenders (1984, P- 20) has argued:
Contrary to what actually happened legally+ fram the
standpoint of econamics the real defendant in the
Department of Justice's antitrust case was not AT&T.
The real defendent was the regulatory cartel of which
ATsT was certainly a part. This cartel was made

local telecarmunicat ions services. This politically
popular subsidy not only created huge welfare losses,
but, as happens with all cartels, also get in motion the
corrective forces of canpetition, the defense of which
caused ATsT to run afoul of the antitrust laws. this,

any industry is campetition which is directed at
relieving the wonopoly power which distorts economic
efficiency... -The real monopoly power present in the
telecanmunications industry was created and fostered by
the political process which regulated this industry.


-29-

The basic outline of a test-marketing experiment is clear, having been
undertaken in other industry settings, most notably in air transportation. 4y/
The experiment would involve establishing a zone of reasonableness within
which AT&T would be free to act without Commission approval. 42/ The zone
would provide for relief fran regulations which require approval for pricing
changes, new service offerings and new facilities construction. The zone
could expand if campetition thrives or it could contract i£ a monopoly

industry structure proves natural in a contestable, equal access environment.

B. ward Versus Upward Pricil ing Flexibility? A zone of

reasonableness can provide for greater downward than upward pricing
flexibility if fears of monopoly pricing so warrant. This would need to be
carefully considered since anomalies in the current structure of rates make
marked upward revisions in rates for some services economically desirable. If
those ananalies were removed or dealt with separately, there would appear to
be several advantages in a zone of reasonableness for pricing decisions that
provides only for downward pricing flexibility.

Suppose the upper boundary of a zone of reasonableness for pricing
decisions were set at current rates with provision for adjustments to reflect
changes in the purchasing power of the dollar and in direct assignment of
access costs. Note, first, that under this approach ATST's ability to exploit
its market power by raising prices would be limited. Any real (as opposed to
naninal) rate increases would require FCC approval and presumably plausible
_

Alf See Elizabeth Bailey et- a> al. (1984).

42/ Kahn (1984) and the Department of Justice (1964) have offered specific
proposals.


-26-

Phillips may be right—campetition in telecammunications may be an
impossibility, but, paradoxically, the only way of discovering whether that is
so is to permit campetition. Hayek (1978, p. 180) advises that:

{Clampetition is valuable only because, and so far as
its results are unpredictable and on the whole different
fran those which anyone has, or could have, deliberately
aimed at...The market leaves the particular cambination
of goods, and its distribution among individuals,
largely to unforeseeable circumstances—and, in this
sense to accident. It is, as Adam Smith already
understood, as if we had agreed to play a game, partly
of skill and partly of chance. This campetitive game,
at the price of leaving the share of each individual in
same measure to accident, ensures that the real
equivalent of whatever his share turns out to be, is as
large as we know how to make it. (emphasis in original)

%

III. Policy Implications
our conclusion is that the best way of discovering whether canpetition
works is to try it. ‘The ultimate proof of whether a self-policing industry
structure is viable lies in the pudding of free competition. Allen (1982,
p. 44) suggests that:
It is entirely sensible to look at market performance rather
than market structure, to assess real productive results of

real market behavior rather than market organization on the
basis of static and bloodless criteria.

One advantage of an approach that focuses on performance rather than
structure is that plausible strategic responses lead to greater competition
rather than less (viz., lower prices rather than higher). As noted earlier,
one disadvantage of utilizing market share as an indicator of market
competitiveness is that less actual campetition can lead to incorrect
inferences of increased campetition. For illustration, suppose AT&T judges
that to be freed fran regulation it needs to Jose 30 share points. One way to

achieve that goal would be to adopt an umbrella pricing scheme that provides


3+

just the opposite of this. The idea of competition is
to have a market structure that without regulation,
induces efficient pricing. a

Looks can be deceiving. That will be particularly so when the processes
which produce what we observe differ fram the processes which underly and
justify use of the observations as indicia of econanic performance or
competitive status or same other phenomenon. In athletics strength-of-
schedule considerations affect evaluation of winning percentage as an index of
comparative team performance. Analogously extramarket considerations affect
evaluation of market data a5 indicia of effective competition in econanic
markets.

“asymmetric regulation" is the name Richard schmalensee (1984) has given
to the FCC's current policy of subjecting AT&T to more stringent regulation than
its rivals in the markets for telecammnications services. 4/ Tnis paper
examines the implications of asymmetric regulation for campetition policy
analysis. In particular, it considers how asymmetric regulation affects
interpretation of market share data as evidence of effective competition or
monopoly Power The basic thesis of the paper is that current regulatory

policy substantially weakens what is already a tenuous connection between

_

4/ The FCC has, for all practical purposes deregulated ATsT's interexchange
competitors. AT&T is still subjected to the full panoply of regulatory
requirements.


-2-

That seems like a simple question to answer, but the simplicity is

deceptive. Counting the competitors would, for example, provide one pasis for --.

an answer. 2/ The problem is that it will often provide an erroneous Or
misleading one. The fact that a single firm operates in a market does not
necessarily make the market a natural monopoly and a candidate for
regulation. Indeed, if the only reason one firm operates in the market is
that entry by other firms has been uneconamically restricted 3/ and regulation
is responsible for the restriction, just the opposite conclusion might be
warranted. AS Alfred Kahn (1971, P+ 146) asks in his regulation textbook, "If
competitors want to enter, how natural can monopoly be?"
symmetrically, the fact that several firms operate in a market does not

necessarily mean that the market is not a natural monopoly. Part of the
answer to Kahn's question is that monopoly can be plenty natural if the basis
for canpetitive entry is inefficient pricing rather than lower costs. The
presence of more than one supplier may indicate the economic viability of
multiple sources of supply or it may reflect, among other things, inefficient
("politicized") pricing of industry inputs and/or outputs and the existence of
what is, in effect, 4 regulatory cartel. AS Almarin Phillips (1982, p- 23)
argues:

Through regulation of one kind or another--legislation,

injunctions, consent decrees, OF regulatory edicts--the

pricing and services of AT&T, the BOCs, and other

non-Bell participants in the switched network can be

arranged so that all are viable. That is, regulations

can be formulated to preserve and protect an inefficient
structure with many firms. Competition, nonetheless, is

_
x7 Analysis of market shares is merely a sophisticated way of counting.

7 Harold Demsetz (1982) explains the concept of properly scaled entry
barriers.


-15-

market power or competitive effectiveness is attenuated. Regulation renders
market share data less meaningful in either sense.

Suppose a market is effectively monopolized and effectively regulated.
In that case the incumbent will have a 100 percent market share and no power
to raise prices above ‘competitive levels. Suppose that instead of limiting a
monopolist's price to the competitive level, regulation requires rate-
averaging, that is, that the incumbent charge uniform prices in different
market segments despite different costs of serving the segments. Under that
arrangement, prices will exceed marginal costs in same areas and marginal
costs will exceed prices in others. In the latter areas, below-cost pricing
deters entry so that the incumbent again has a 100 percent share but again
possesses no market power. 20/ In other areas, above-cost pricing attracts
entry so that the incumbent's market share in these areas will decline. That
decline is, however, of limited significance since it is merely a byproduct of
economically inefficient pricing. Indeed, what causes the decline in one set
of markets is precisely what prevents it in the other set. In this regard,
note the inconsistency in requiring loss of market share for deregulation in

the face of pricing policies that prevent such a loss fran occurring. 21/

20/ As Landis and Posner (1981, p. 976) note:
In this case the causality between market share and
price is reversed. Instead of a large market share
leading to a high price, a low price leads to a large
market share; and it would be improper to infer market
power simply fran observing the large market share.

21/ A similar inconsistency is entailed in requiring ex ante cost reductions
to justify price reductions that lead to ex post cost reductions because of
fixed cost spreading. To require, as a precondition for price cutting, the
cost savings price cutting induces is obviously to preclude such cuts.


results, but rather a fair test that produces unbiased information. 5/ If an
effectively canmpetitive market structure proves natural in an open, equal
access envirorment, then deregulation will be warranted. A “camnpetitive"
industry structure which is merely an artifact of regulatory division of the

market supplies scant basis for prudent policymaking.

Il. Natural Monopoly: The Problem of Authentication &

The defining characteristic of a natural monopoly industry is cost
subadditivity. 7/ Subadditivity implies that costs of supplying a given set
of outputs will be lower if production is carried out by a single firm rather
than by two or more firms. Oost subadditivity may pose a policy dilemma, for

if technically efficient (i.e., least cost) supply requires production by a

5/ The flavor of this policy prescription has been well captured by
Cammissioner Dennis Patrick in remarks before the Federal Camunications Bar
Association. Patrick (1984, p. 7) observes that:

[T]he Canmission cannot create competition: the demand,

supply, and cost characteristics that will support

campetition either exist or they do not at any given

point in time.
Patrick assumes such conditions do exist in the interexchange market, but he
(1984, pp. 6-7) warns that:

Failure to recognize the impact of our continuing

regulations could lead us to misjudge how competitive a

market really is absent regulatory intervention. Our

misjudgment would become apparent only after decontrol,

when the market returned to its natural equilibrium,

undisturbed by our regulatory intervention.

£/ Thomas Sowell (1980) analyzes the characteristics of different processes
Of authentication.

7/ The concept of subadditivity is defined and explained in W. Baumol et. al.
(1982).


-21-

welfare. 28/ In Schumpeterian terms, “the problem that is usually being
visualized is how capitalism administers existing structures, whereas the
relevant problem is how it creates and destroys them." 29/ He (1950,

p. 84) argues that:

{t)n capitalist reality as distinguished fran its
textbook picturer.-- the canpetition which counts is
that...fran the new canmodity, the new technology, the

new source of supply, the new organization (the largest-
scale unit of control for instance)--campetition which
canmands a decisive cost Or quality advantage and which
strikes not at the margins of the profits and the
outputs of the existing firms but at their foundations
and their very lives. That kind of competition is as
much more effective than the other as 4 bombardment is
in canparison with forcing a door, and so much more
important that it becomes a matter of camparative
indifference whether campetition in the ordinary sense
functions more OF less pranptly; the powerful lever that
in the long run expands output and brings down prices is
in any case made of other stuff.

on both the Hayekian and Schumpeterian views, canpetition is an
evolutionary process of discovery and selection, rather than simply 4 method
for allocating given means among known ends. An important implication of the
idea that competition is a discovery procedure is that closed monopoly (or its
less efficient first-cousin, the regulatory cartel) is a procedure for
remaining ignorant. No single organization can possess all the knowledge and
skill that are relevant for product ion of any but the simplest goods and
services. Restricting competition, particularly by restricting market entry

oo

28/ Product campetition itself frequently possesses an important price

dimension. For illustration, suppose 4 firm produces a windshield wiper that
lasts twice as long as its rivals', but is only half again more expensive.

That product innovation effectively lowers the price of the service (viz-»
windshield wiping).

29/ See Schumpeter (1950, p- 84)-




-8-

This presumes that there are practicable methods for determining whether
“natural monopoly elements" are important. We consider three methods for
ascertaining whether the telecamwmnicat ions industry cost function exhibits
subadditivity: (1) empirical estimation of industry cost relationships;
(2) analysis of market’ shares; and (3) the test of open market campetition.
A. Empirical Estimation: In principle, one way to determine whether an

industry cost function displays subadditivity is to measure it directly using
econametric tools. 11/ There are, however, several difficulties with this
approach that preclude its providing a solid foundation for policymaking in
the instant setting. First, the task itself, while describable, is dauntingly
difficult and will usually prove impossible to carry out. As Baumol, Panzar
and Willig (1982, pp. 170-172) note in their book on contestable markets, an
unfortunate attribute of the subadditivity condition that unavoidably
camplicates empirical tests to determine whether or not it is satisfied is
that it is a "global" not a “local” concept. They (1982, p. 171) explain
that:

[U]nlike the property of scale econanies at y [same set

of outputs), subadditivity at y cannot be conclusively

assessed fran data about costs only in the vicinity of

y. The cost surface must be scrutinized not merely in

the neighborhood of that point, but also all the way to

the axes and the origin. This is a very demanding task

for empirical work because it is likely to require data

well outside the range of available observations. If in

recent decades a firm has produced no quantities varying

by more than say 25 percent from its current output,

then there will be no statistical data (except perhaps

for some obsolete figures) that can indicate the shape

of the cost function anywhere near the origin or the

axes. Thus, the data requirements of a statistical test
of subadditivity can be very severe indeed.

11/  Econanists' policy prescriptions generally presume (perhaps without
basis) that cost relations can be (or have been) accurately estimated.


potential substitutes also ignores other important functions that competition
performs and regulation does not. 10/
Schmalensee (1984, pp. 3-4) recammends that:

As a permanent, long-run policy, the Commission's choice
should be between regulation of a single supplier of
: telecammuniaations services (if natural monopoly
elements are important) and unregulated competition (if
they are not).

ee

10/ Campetition not only forces prices to reflect costs, but also leads costs
to be minimized. If costs are higher than they need to be, the fact that
prices reflect costs should be of little consolation to consumers Or
regulators. Similarly, if products consumers would prefer to buy are not
offered for sale, the fact that the prices of those that are offered for sale
reflect costs should again offer little consolation.

It is equally true that regulation may perform certain functions that
competition does not. For example, regulation may permit political transfers
through price manipulation, what Richard Posner (1971) has described as
“Taxation by Regulation." Gerald Faulhaber (1975, p- 972) argues that:

If the public authorities desire both subsidizing prices

and economies of scale, then the coercive authority of

the government must be employed to restrict or prohibit

entry into the market. Thus, even when the public

enterprise enjoys increasing returns to scale, if the

regulators adopt a pricing policy of subsidization,.--

entry must be restricted.
The problem with restricting entry is that it means excluding potentially more
efficient suppliers and foregoing the beneficial effects of potential
campetition. It is possible to achieve social goals without foregoing the
benefits of open entry through a more explicit scheme of taxes and direct
subsidies. As Baumol et_al. (1982, pp. 365-366) argue:

[O]bjectives not automatically taken into account by

market forces may nevertheless be pursued...by a policy

that relies upon general financial inducements, not

case-by-case intervention and direct controls. ..The

costs of the pursuit of the special objectives are borne

by society as a whole, not by particular classes of

consumers who have the burden thrust upon them by cross

subsidies either voluntarily adopted by or imposed upon

firms by the authorities.


~40-

, Industrial Market Structure and Economic Performance (1980).

Schmalensee, Richard, “On the Use of Econamic Models in Antitrust: The
ReaLemon Case," U, of Pa. Law Review (1979).

, "Statement of Richard Schmalensee," Attachment 4 to
Canments of AT&T in CC Docket No. 83-1147 (April 2, 1984).

Sehumpeter, Joseph, C4pitalism, Socialism and Democracy (1950).

Smirlock, M., et. al. “Tobin's q and the Structure-Performance Relationship,"

American Economic Review (December 1984).

Sowell, Thomas, Knowledge and Decisions (1980).
Spence, Michael, Market Signalling (1974).

Stigler, George, “Monopoly and Oligopoly by Merger," in The Organization of
Industry (1968).

, "The Econanist and the State," in The Citizen and the State

(1975).

Sullivan, Brian, "Equal Access--Who Benefits, Who Pays?," in Changing Patterns
in Regulation, Markets, and Technology: The Effect on Public Utility
Pricing, Harry Trebing (ed.) (1984).

U.S. Department of Justice, Camments in CC Docket No. 83-1147.

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

Waverman, Leonard, "The Regulation of Intercity Telecanmunications,” in
Promoting Competition in Regulated Markets, Almarin Phillips (ed.)
(1975).

Wayne, Leslie, “MCI Loses Some Sparkle," New_York Times (February 12, 1984).

Wenders, John, “An Econanic History of the U.S. Telecammunications Industry to
1995: A Public Choice Perspective," in New Directions: State Regulation
of Telecarmunications (1984).

Williamson, Oliver, "The Vertical Integration of Production: Market Failure
Considerations," American Econamic Review (May 1971).

, “Franchise Bidding for Natural Monopolies - In General and
With Respect to CATV," The Bell Journal of Econamics (Spring 1976).

, “Transaction Cost Econamics: ‘The Governance of
Contractual Relations," Journal of Law and Econanics (1979).

zerbe, Richard, “Regulatory Lessons in General," in New Directions: State
Regulation of Telecammunications (1984).



-28-

handicapping. 38/ Current access pricing is not cost-based, but rather
subsidizes certain interexchange carriers whose network access is technically
inferior and certain local telephone services. 39/ the assumption that no
carrier would buy infetior access at a price reflecting what it actually costs
to produce (because no consumer would), the nature of canpetitive rivalry
under equal access conditions will differ significantly fran that which exists
now. 40/ That suggests the limited significance of current market data, on the
one hand, and a logical starting point for the test-marketing of canpetition,

on the other.

eo

38/ In other areas (e.g. private lines), equal access is not an issue.

39/ Access pricing through regulatory and political processes has proven
susceptible to exploitation through prinkmanship. ‘The goverrment'S
camitments to canpetition and universal service have proven irresistible
targets for such tactics. Few with the power to hold those canmitments
hostage have failed to try to exercise it. And few who have tried have failed
to make gains as a result, thereby encouraging others to try. A fundamental
problem is, as the NTIA has observed in it camments in the ATsT deregulation
inquiry, that the FCC, perhaps through no fault of its own, may be incapable
of mollifying all the contesting interests. It is not clear what it would
prove if it could. ‘The purpose of regulatory reform is presumably not to
sustain a cartel of certain producers and consumers with the FCC as a cartel
manager. It is to provide an institutional framework that allows buyers and
sellers in the marketplace to play the major role in determining an
appropriate allocation of resources within the industry. Phillips (1983,
p- 292) suggests that:

In brief, amd ona piecemeal basis at that, the FCC--and

even more 80 the Department of Justice--seems to be

seeking rates that will sustain the emerging and

increasingly inefficient organizational structure of the

telecawmnications industry. ‘They should be doing just

the opposite. They should be Jooking for an efficient

organizational structure so that efficient rates could

be developed.

40/ See Brian Sullivan (1983).


-27-

an opportunity for its rivals to grow. 36/ That strategy implies higher
prices for consumers, but it leads to a fall in ATsT's market share and the
incorrect inference that the market is in same meaningful sense more
effectively campetitive. 3y/

+ In contrast, strategic gaming of judgmental criteria that focus on
competitive performance would lead to greater competition. I£ AT&T wanted to
behave strategically, the way to do sO if competitive performance were the
decisionmaking criterion for deregulation would be to compete like crazy. But
that is precisely what is needed to determine if a self-policing industry
structure is viable. I£ such a structure were not viable, surely it would be
better to discover that before giving ATsT freedom to raise prices at its

discretion.

A. Test-Marketing Competition: The practical policy question is how to

arrange a market experiment that provides a relatively unbiased test for the
presence of natural monopoly elements, while simultaneously protecting
consumers from any monopoly fallout. In switched services, 4 meaningful
experiment and valid test results probably require widespread availability of

so-called "equal access” and, just as importantly, an end to access cost

eo

36/ Government agencies with an institutional stake in the survival of
particular firms may not object to such behavior. They may well seek to
instigate it.

37/ Wenders (1984, p. 35) suggests that:
No one concerned with econanic welfare in the
telecammunications market can logically argue
that...toll rates should be kept high and that the
States and the FCC should practice handicapped
regulation and umbrella pricing in toll markets.


market share and market power. This implies that if decisions about
deregulating AT&T are based primarily on the size of its market share, the
pace and extent of deregulation are likely to be economically nonopt imal in
the sense of “too little-too late" or “too much-too soon" (possibly both).

The paper is organized in the following manner: Section II analyzes the
problem of how information relevant to questions about the appropriate extent
of government intervention in the marketplace can be discovered. We consider
three methods for determining whether provision of any or all long-distance
telecammunicat ions services is a natural monopoly: (1) empirical estimation
of industry cost relationships; (2) analysis of market shares; and (3) the
test of open market competition. Our analysis suggests that of the three, the
Jatter is the only procedure capable of discovering whether the market isa
natural monopoly. Competition provides the test of whether monopoly is
natural: Does only one firm survive the canpetitive process?

Implications for policy are discussed in Section III. Our basic
conclusion is that if what the FCC wants to know is whether a canpetitive
(i-e., self-policing) industry structure is viable and regulation unneeded, it
should “cest-marketTM actual competition. Attempts to achieve same desired
configuration of market shares through regulatory means may serve other ends,
but they invalidate the use of market information as an indicator of
competitive status or comparative efficiency. To promote consumer welfare,
the FCC should organize regulation so that feedback information about market
processes and outcomes accurately reflects basic econanic forces of supply and
demand (including the true canpetitive capabilities of rival firms), while at
the same time assuring that consurers are protected from monopoly abuse. Fram

an informational standpoint, the FCC's goal should not be to produce particular


-18-

quality, product design, and marketing, and succeeded in
matching or exceeding actual and would-be competitors,
did they endure.

Some leading firms with large market shares have
believed that they could behave monopolistically. The

“ market informed them of their error and, frequently too
late for the health of their enterprises, taught them
and other businessmen that the attempt to monopolize is
more often the road to losses than to profits, absent
the government as an ally.

Analysis of market share data often provides the starting point for an
economic evaluation of market competition. Traditional antitrust enforcement
still relies heavily upon market share data and related information. Modern
analysis strongly sugyests that one cannot unambiguously equate declining market
shares with improved industry performance, particularly when market shares are
determined in whole or part by regulation (or strategic responses to regulation)

rather than by campetition.

C. “Competition as a Discovery Procedure" 23/: The theory of perfect

competition posits a market in which there are a large number of buyers and
sellers trading a homogeneous good, in which knowledge about consumer tastes,
production techniques and trade opportunities is complete, and in which there
are no restraints on the movement of prices and resources. Lack of realism in
a scientific model is not necessarily a vice and can be a virtue. 24/ There

are purposes for which the theory of perfect canpetition supplies a useful

23/ See Friedrich A. Hayek (1978). This subsection draws heavily on Hayek's
work.

(24/ See Milton Friedman (1971).


cost business and attacking where it tries to make up the difference has been
one of the factors accounting for ATéT's rivals' rapid growth to date. Cross-
subsidization represents an econamically irrational business tactic in open
markets.

. ‘

D. Standards for Downward Pricing Flexibility: In the law and

econanics literature, a marginal cost standard for fair pricing has achieved
some currency. 48/ A marginal cost test does a reasonably good job of
balancing the costs of possible decision errors described earlier. In
addition, prices that cover relevant marginal costs will generally not exclude
equally efficient rivals and they are incampatible with cross-subsidization
attempts. No subsidy can occur as long as the price of a product exceeds the
costs directly attributable to its production. To the contrary, when prices
exceed marginal costs, a surplus is generated which can contribute to recovery
of otherwise nonallocable costs.

In econanic discussions of fair pricing, second-best considerations (in
particular, problems of fixed cost recovery) are generally submerged to
simplify analysis. In telecanmunications, problems of fixed cost recovery
loan large. Implementation of econamically efficient pricing has proven
politically infeasible in the short run and the long-term prospects for a
full-blown system of flat fee access charges remain unclear. This implies
that conventional fair pricing standards need to be adjusted to reflect the

existence of a cost recovery constraint and be capable of drawing relevant

48/ See McGee (1980).


-36-

econanic distinctions when confronted with pricing proposals that are
necessarily more camplex than regulators are used to seeing (or may wish to
see).

Posner (1977) is highly critical of regulatory policy for its historical
failure to draw econanic distinctions which should be drawn. Among other
things, he faults regulation's tendency to equate discrimination with a
difference in rates and nondiscrimination with rate uniformity, as well as its
failure to distinguish multipart pricing fram price discrimination. He
conjectures that part of the reason for regulatory suspicion of price
differences is that they are often triggered by the threat or actuality of
competition in a subset of relevant business segments. They “look like" a
discriminatory response to competition, although they may be easily
rationalized in terms of the economics of supply and demand, Other factors
the same, an increase in supply relative to demand (associated with, say, new
entry) implies a lower equilibrium price. In that circumstance it would be a
mistake to characterize the incumbent's price reduction as predatory. In
economic terms what may actually be happening is that the new firm's addition
to supply is driving down the best price available to the incumbent. Rate
differences which arise fram the need to meet competition in contested market
segments (or to anticipate it in potentially contested segments) are neither
unreasonably discriminatory nor predatory. They are camnpetitive.

Posner (1977, p. 261-262) remarks that:

Multipart pricing resembles but must be distinguished
fram price discrimination. Under price discrimination,
price varies with willingness to pay. But the purpose
of price discrimination is not to enable fixed costs to
be recouped in a manner that permits marginal purchasers
to be served; it is to maximize the excess of revenues

over costs. Multipart pricing is designed to maximize
output consistently with avoiding a deficit; price


-24-

requires that one take on faith the existence of certain cost relations and
discount any potentially salutary effects of actual or potential
competition. Absence of evidence implies that a policy of free entry also
rests on faith, but as Baumol et. al. (1982, p. 222) aver, “cases in which
entry may lead to sams social inefficiency should not be taken to tilt the
scales against the presumption that freedam of entry is socially beneficial.”
The burden of proof should always be on those who would restrain such freedan.
The advantages of the campetitive approach have been well summarized by Baumol
et. al. (1982, p. 222) as follows:

{F]reedan of entry, indeed the mere threat of incursions

by entrants into the market, may effectively discipline

the monopolist, even if entry is never successful. It

can force the monopolist to curb his avarice and forgo

profits he might otherwise have enjoyed...Potential

competition can also force the monopolist to produce

with maximal efficiency, and to hunt down and utilize

fully every opportunity for innovation. Perhaps most

surprising of all, it can induce the monopolist to

institute those (Ramsey) prices which welfare theory has

shown to be requisites of Pareto optimality under a

profit constraint. In short, the threat of entry can

force virtuous behavior upon the monopolist, for if he

behaves badly his monopoly becomes vulnerable. In our

analysis, it is freedan of entry alone that is capable

of accomplishing all these things. (emphasis in
original)

Assuming what a real theory of canpetition would explain, the theory of
perfect campetition analyzes how well a particular (generally infeasible) form
of market organization solves a problem different fram the one we actually
face. The same criticism can be made about the theory of regulated
monopoly. ‘That theory purports to demonstrate how regulation can protect
consumers fran monopoly exploitation given all the information about consumer

preferences and producer costs that is similarly taken as given in the theory


“Exchange service and interexchange service are intrinsically natural
monopolies. “«

Not many econamists disagree. what they question is the degree of
the cost advantage these natural monopolies afford and whether it is
sufficient to warrant. regulatory barriers to entry. Jet the free market have

not acknowledge what surely they know and that is that a combination of
regulatory handicapping of the currently ‘daminant! supplier and anxieties on
that supplier's part that his response to competition will be characterized as
anticampetitive altogether precludes the working out of that econanic lesson
in the real world."

Alvin von Auw


-11-

to capture the effects of technological change.-- {T)here
is remarkable consistency in the overall conclusion that
the scale coefficient significantly exceeds the unity
value associated with constant returns to scale...

[T]he results of the econometric studies are consistent

with independent engineering and other nonstatistical
estimates of cost functions. In addition to strict

: scale econamies, the latter suggest the presence of
econamies of scope and of economies of traffic
density. Further they confirm the econanetric evidence
that subadditivity in costs pertains to interexchange
transmission as well as to the local exchange services.

Evans and Heckman (1983, Pp- 147-148):

Having examined the major Bell System econometric studies
relied upon by Rosse, We conclude that (a) the Vinod studies

rely on an inappropriate statistical technique; (b) the
Christensen study uses an invalid and irrelevant aggregate
measure of telecamunications outputs; and (c) none of these
studies provide credible evidence concerning whether a single
firm can provide any Or all telecanminications services more
efficiently than several firms...The most. camprehensive of the
Bell Canada studies--the Fuss and Waverman study—-rejects the
hypothesis that there are scale economies in private line
service and other telecammunications services. 13/ The most
reasonable conclusion one can make from the studies reviewed
by Rosse is that, to the extent these studies shed any light
at all on the issue of whether a single firm can operate any
or all telecommnications services more efficiently than
several firms can, they suggest that the provision of

telephone service by a single firm may not be the most
efficient arrangement available to society.

Given pointed conflicts in expert opinion (real or, potentially, fabricated)

and judicial-regulatory-political inability to judge the merits in technical
__

13/ Waverman (1975), howevers concludes that the industry is a natural
monopoly on the grounds that there are important transactional efficiencies
associated with single-entity organization. Problems of cost allocation and
recovery have obviously been a prime focus of public policymaking under the
new industry organization in telecanmunications. Ironically, these problems
would not (or at least need not) exist under integrated monopoly. Indeed,
integration is generally posited as a solution for the kinds of difficulties
now confronted in this area. See Oliver Williamson (1971 and 1979), Roland
McKean (1971) and F.M. Scherer (1980, Dp- 300-305).


-13-

market share data and (ironically) a signal to deregulate. ‘That kind of
perverse outcane stemming fran strategic responses to judgmental criteria is
what economists refer to as 4 signaling problem. 16/

Market power is the ability to raise prices above costs without suffering
serious competitive consequences. In price theoretic terms, market power is
measured as the inverse of the elasticity of demand a firm confronts. 17/

Market share/concentration ratio measures are simply observable structural
characteristics of markets which indicate in rough terms what a firm's elasticity
of demand would be if it could be directly observed. Most analysts argue that a
large market share is not sufficient to show market power because it does not
take into account the ability of market entrants or other market participants to
offset monopolistic output restrictions. 18/ Inferences based on current market
shares will generally understate the actual elasticity of demand a firm confronts

anda hence overstate the actual extent of its market power.

_—_—_—_

16/ On the econanics of signaling, see Michael Spence (1974). The specific
disabilities of market share/concentration ratio measures as policy signals
were one of the principal criticisms leveled against the failed industrial
deconcentration legislative proposals of a decade ago. Those proposals called
for the breakup of firms with large market shares in concentrated

industries. Rather than promote competition, such laws would have discouraged
it by providing disincentives for firms to campete and grow. Note also that a
firm's market share (and the industry concentration ratio) is not solely a
matter of its own doing, depending also on the behavior of its rivals as well
as the government in the case of regulated industries. That point is relevant
to our discussion as well.

ly Elasticity is a measure of demand sensitivity. If demand is very
sensitive to price changes (because of the availability of substitute
products), elasticity is large and its inverse is small.

18/ William Landis and Richard Posner (1981, p- 947) note that “market share
‘Alone is misleading” and that there are pitfalls in mechanically using market
share data to measure market power. They argue that an appropriate measure of
market power “will attempt to capture the influence of market demand and
supply elasicity."


The FCC Office of Plans and Policy's Working Paper Series presents
staff analysis ard research in various states. These papers are intended to
stimulate discussion and critical canment within the FCC, as well as outside
the agency, on issues in telecammunicat ions policy. Titles may include
preliminary work and progress reports, as well as completed research. ‘The
analyses and conclusions in the Working Paper Series are those of the authors
and do not necessarily reflect the views of other members of the Office of
Plans and Policy, other Camnission staff, or the Comission 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 fran the International Transcription Services, Inc.,
FCC, 2100 M Street, N.W., Room 140, Washington, D.C. 20037, (202) 857-3800.
Copies are also available fran The National Technical Information Service,
5285 Port Royal Road, Springfield, VA 22161 (703) 487-4650). ‘The inside back
cover contains a list of previous titles.

For information on the Series, contact the Office of Plans and Policy, Federal
Communications Commission, Roam 822, 1919 M Street, N.W., Washington, D.C.
20554, (202) 653-5940.


-34-

The article reports that Mr. McGowan “isn't even afraid of ATsT" and "feels
ATsT's aggressiveness will be limited, especially since the one way AT&T will
became unregulated is by reducing its market share.” As Mr. McGowan puts its

Why would they lower prices to regain a monopoly when
they are trying to get out fram under regulation?
‘

Note that deregulation providing for no upward pricing flexibility
discourages predatory pricing by removing the prospect of a payoff to below-
cost pricing. It would be econanically irrational to suffer losses with no
prospect of gains. 47/ The presence of regulatory constraints on
discretionary price increases (price ceilings) mutes the question of how
rapidly competitive pressure can be brought to bear in the unlikely event that
unwarranted price increases are attempted in open markets.

ATsT currently possesses a large share of the interexchange market, but
that market is one which, as a result of divestiture and removal of regulatory
barriers to entry, may now be contested by many different firms. This implies
that if AT&T were to attempt to lever its current position in the
interexchange market into dominant positions in other markets, it would (more)
quickly lose its daminance in the interexchange market. One might well
question the wisdan and likelihood of a business strategy whose success is
improbable in any event given the large number, size and econanic stature of
prospective prey and, moreover, whose execution leads, necessarily, to its
failure. Cross-subsidization attempts by ATsT would constitute tremendous

strategic business opportunities for its rivals. Saddling AT&T with below-

41/ This is the basis for Baumol's (1979) proposal that price reductions by a
monopolist in the face of entry be made quasi-permanent.


-22-

by new firms, reduces the chance that better products or lower-cost methods of
production will be discovered and subjected to a market test.

Phillips (1982, p. 22) argues that:

So long as a natural monopoly with scale, scope and

density economies has the incentive to offer new,
> technologically possible services, it is always more

efficient to have the services provided by that

monopoly--subject to reasonably effective regulation—
than to have the same services carried by new entrants.

The problem with that argument is, first, that regulation itself may operate to
inhibit technical innovation by removing the profit incentive to innovate. 30/
If a firm's profits are restricted, its incentives to lower costs will be
reduced. And the more effective regulation is, the more it will work to

reduce such incentives. Second, actual pricing under regulated monopoly in
telecammunications cannot be defended on efficiency grounds, including the
efficiency with which politically inspired cross-subsidies are carried out. 31/
Phillips himself explains attempts to enter the industry in part on the basis of
faulty incentives provided by pricing decisions under the regulated monopoly
regime. ‘These are, as he argues, properly “regulatory issues," but if the
efficacy of closed monopoly depends on the existence of “reasonably effective
regulation,” poor regulatory performance in practice weakens the case for

closed monopoly. Phillips’ policy prescription amounts to an argument that if

30/ Regulated finns may nevertheless do same innovating if utility
maximization in the presence of a profit constraint leads managers to
substitute technical innovation for profits.

31/ James Griffin estimates the economic welfare losses associated with

current inefficient pricing practices to be on the order of $1 billion per
year. He (1982, p. 66) concludes that "the existing degree of cross

subsidization of local service by long-distance service cannot be justified by
welfare econanics."


Implications of Asymmetric Regulation
for Competition Policy Analysis */

by
John Haring **/

eo

*/ The views expressed are those of the author and should not be construed to

Teflect those of the Federal Carmunications Cammission or any other member of
its staff.

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


-30-

cost justification. Furthermore, if rate ceilings were indexed to direct
assignment of access costs, AT&T would be prevented fran exercising any market
power by simply not lowering rates when access costs are directly assigned
(ise., when such costs«are no longer borne by ATsT).

The principal fear of deregulation is that ATsT will be able to raise
rates and not suffer sufficiently immediate adverse consequences in terms of
loss of business. There is no reason why deregulation cannot proceed in
phases with upward pricing flexibility deferred until a competitive track
record is established. Sequential decisionmaking avoids the problem of having
to describe all possible contingencies and appropriate adaptations in
advance. Events are allowed to unfold and policy responses are keyed to what
actually happens. A ceiling approach insures that consumers are made no worse
off as a result of deregulation since what is being deregulated is price
cutting not price gouging. This also has important implications for the
question of rate deaveraging.

Effective canpetition leads prices to reflect costs. This implies that a
regime of averaged rates may not be sustainable in the face of canpetition.
The reason is simply that consumers who confront rates that exceed costs will
tend to migrate to lower-priced canpetitive alternatives and that may make it
difficult to maintain below-cost rates. Competition may be incanpatible with
broadly averaged rates. Assuming the upper boundary of a zone of
reasonableness for pricing decisions were periodically adjusted to reflect
changes in the purchasing power of the dollar, gradual rate deaveraging could
occur without trauma. As time passes, it is likely that technical advance and
fixed cost spreading will generate cost reductions. With downward pricing

flexibility, AT&T would thus be able to deaverage its rates by lowering prices


-39-

Kelley, Daniel, "Deregulation After Divestiture: The Effect of the ATsT
Settlement on Competition," OPP Working Paper #8 (April 1982).

Koller, Roland, "The Myth of Predatory Pricing,” Antitrust Law and Boonamics
Review (1971).

Landis, William and Richard Posner, “Market Power in Antitrust Cases," Harvard
Law Review (March 1981).

McGee, John, “Efficiency and Econamies of Size,” in Industrial
Concentration: The New Learning, Harvey Goldschmid et. al. (eds.)
(1974).

, “Predatory Pricing Revisited,” Journal of Law and Econanics
(1980).

McKean, Roland, “Camment on Williamson," American Economic Review (May 1971).

Meyer, John, et. al., The Econamics of Competition in the Telecanunications

Industry (1980).
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Noll, Rey M.J. Peck and J.J. McGowan, Econamic Aspects of Television
Regulation (1973).

Patrick, Dennis, “Dungeons and Dragons: The Road to Telephone Deregulation,”
Remarks Before the Federal Cammunications Bar Association (September 20,
1984).

Phillips, Almarin, “The Impossibility of Competition in Telecammmnications:
Public Policy Gone Awry,” in Requlatory Reform and Public Utilities,
Michael Crew (ed.) (1982).

, “The Pseudoeconanics of Access Charges," in Boundaries
Between Competition and Econamic Regulation, J. Rhoads Foster et. al.
(eds.) (1983).

Posner, Richard, "Taxation by Regulation," Bell] Journal_of Economics and
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, Antitrust Law: An Econamic Perspective (1976).

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Scherer, F.M., "Econamics of Scale and Industrial Concentration," in
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-25-

of perfect canpetition. 34/ Tf that information were truly given or could be
costlessly produced, the question of appropriate industry organization would
be a matter of little consequence. It is precisely because knowledge is a
soarce good that economic organization matters and that interesting problems
of comparative institutional choice arise.

The actual performance of regulation is nothing to write home about. On the
view espoused here, regulatory failure is not the result of econamic illiteracy
or faulty bureaucratic incentives, although those would certainly need to be
included on any jist of important contributing factors. 35/ The yeal source
of failure is that without the presence or threat of canpetition, 4 regulator
cannot know what needs to be known for regulation to work in even a mediocre
way, or, for that matter, to determine whether regulation is even needed.

The telecammunications industry (or parts of it) may be a natural
monopoly, but ultimately the only way of determining whether that is S° (or
continues to be so in the future) is to allow free competition. Free competition
is canpetition which permits firms to succeed or fail primarily on the basis of
consumer judgments expressed directly in the marketplace + rather than, Sayr
governmental judgments which mainly reflect the legal pleadings and political
lobbying of industry participants and the structure of incentives confronting

regulators and politicians.

_

34/ That theory also takes aS a given the campetence of the state to achieve
desired goals, that is, it assumes that the structure of incentives
confronting regulators will lead them to behave in ways that pranote desired
goals. See G Stigler (1975)

35/ See Roger Noll (1971).


+

The reason global measurement is required is to test whether many small firms
or medium-sized firms or a canbination of the two can produce more cheaply
than can a single producer.

: The second problem with econametric authentication processes is that the
state of the relevant art, both in general and specifically in terms of the
instant problem, is not such as to inspire or permit great confidence in its
findings. On the general merits of using econometric tools to measure
econanic cost relationships, John S. McGee (1974, p. 68 and p.- 88) remarks

that:

When I began to study econanics, I had high hopes that
statistical analysis would solve these and other
mysteries. Such a hope was naive then; it is naive

now. Apart from expense, there are intractable problems
involving accounting data; the determination and
allocation of administration, planning, and other
crucial costs to the outputs being measured; the
interdependence of costs fran one production period with
those of others; and so on. All in all, such studies
are at least as likely to mislead as to inform. At
best, they would inform only about the irrelevant past.

On my reading of both theory and the evidence,
statistical cost and engineering studies teach us
precious little about even the relationship between
business size and cost. If he likes, an optimist can
await the day when we will have learned a lot about
costs. I think he will have a very long wait.

Even those who are more favorably disposed toward this approach admit that
there are serious difficulties in applying it. ly

—_—_—

12/ In the exchange fran which the McGee quotes are drawn, F.M. Scherer
(1974, p. 97) grants that “the problems in measuring scale economies are
tough."


-12-

disputes, there seems little prospect for econometric resolution of the
‘existence of natural monopoly’ question.

B. Analysis of Market Shares: Market share is a frequently cited

measure of market power. If an industry really were a natural monopoly, the
inevitable result of uhregulated (i.e., real) campetition would be a single
firm and that firm would obviously possess a 100 percent market share. It
does not follow that a high market share implies market power or that an
unconcentrated industry structure implies effectively canpetitive
performance. High market share may be a necessary but is not a sufficient
condition for market power. 14/

AT&T's market share has been cited as evidence (and as a source) of its
market power and a decline in its share has been suggested by same as a
condition for deregulation. 15/ The premise that makes loss of market share a
requirement for deregulation is that such a loss signals increased campetit ion
and reduced need for regulation. That this is actually (or only) the message
share data transmit is by no means obvious.

One possibility is that a firm may sacrifice market share by simply not
campeting as vigorously as it otherwise might. It would, in fact, have
positive incentives to do that if loss of market share were made a condition
for being freed from regulation. In that case, what is actually reduced

campetition would be interpreted as increased campetition on the basis of

14/ Low market shares may be consistent with market power in the presence of
effective cartelization. Economists generally argue that effective
cartelization in a large-numbers (low market share) setting is unlikely
without government involvement.

15/ See Comments of MCI in AT&T Deregulation Inquiry (Docket
No. 83-1147).