[An updated version of this article can be found at Telecommunications in the 2nd edition.]
Telecommunications is important for two reasons. First, it plays a vital role in the organization and operation of the modern global economy. Second, the problems associated with regulating and organizing the telecommunications industry have stimulated a great deal of economic analysis that is important in its own right and relevant to other sectors of the economy as well.
Telecommunications and the Information Age Economy
It would be difficult to overstate the significance of telecommunications in today's economy and virtually impossible to overstate its likely importance in the future. In the last quarter of the twentieth century, telecommunications has become the central nervous system of the economy. Just as the railroads once promoted economic growth and development, telecommunications is now globalizing markets, reducing transactions costs, expanding productivity, and directly increasing economic well-being.
An astounding array of technical advances is constantly reducing costs and expanding capabilities in telecommunications. The forces that are driving down costs and expanding supply capabilities involve advances in microelectronics, photonics, computer software, network architecture, high-definition television, and superconductivity. Many of these advances are simultaneously reducing the costs and expanding the capabilities of complementary goods and services (e.g., electronic data bases and the personal computers that interact with them). At the same time, we are raising a generation of computer-literate consumers and producers with a taste and propensity for interactive communication.
The use of telecommunications in the production and marketing of goods and services is ubiquitous. For many companies telecommunications has become an integral part of the production process and is itself becoming part of the product firms supply either as a value-added service or as part of the product itself. Telephonic order entry and credit validation make transacting business convenient. Customer-service telephone lines provide an excellent way to supply product information and guarantee customer satisfaction. General Electric now builds telecommunications capabilities right into the medical equipment it supplies to hospitals. GE's technicians can dial up the equipment from a central location, do remote monitoring and diagnosis, and implement a solution very rapidly if a problem develops or is anticipated.
Globalization of markets and businesses also relies upon intensive communication and extensive telecommunications capabilities. To bridge time-zone differences, companies are increasingly using video and teleconferencing services.
Economic Organization of the Telecommunications Industry
Time in the telecommunications industry is generally dated before and after the breakup of the Bell System on January 1, 1984. The breakup—AT&T had to divest the Bell operating companies—resulted from a government antitrust suit. Before Ma Bell's breakup, most of the telecommunications industry in the United States was a unified, integrated monopoly, although the Bell System had always coexisted with a number of smaller operators. The Bell System's breakup was, in principle, designed to segregate the competitive portions of the telecommunications industry (telephone equipment and long-distance service) from the monopoly portions (local service). Competitive market forces would govern the equipment and long-distance segments, while government regulation of local service would continue.
Ironically, seven years after divestiture, the long-distance business remained heavily regulated while the market for local services, in several notable respects, became significantly more competitive. While many key questions about which rules should govern competition in long-distance remain unresolved, competition at the local exchange is at hand and poses closely related policy issues and dilemmas.
To understand unfolding events in this dynamic sector of the economy, it is worthwhile to step back and focus on some salient features of the industry's technological and regulatory landscape. A telephone network is a big, lumpy asset. A substantial portion of the asset's costs are incurred up front, merely to build the network and provide the option of use, so to speak, rather than actual usage. The cost of actually using a telephone network is relatively small compared to the cost of the network investment.
The primary goal of government regulation of telephony has always been to promote telephone service for everyone. There is a potential economic justification for this government intervention grounded in the existence of what is called a consumption externality. That is, your presence on the network makes the network more valuable to me and vice versa. The existence of this (or any) kind of externality does not, by itself, justify intervention. It merely suggests that particular interventions could conceivably increase economic welfare.
The particular method that the government historically chose to achieve universal service was to set a low subscription fee for telephone service. The fee was sometimes below the actual cost of hooking subscribers up to the network and maintaining their network access. In sparsely populated rural areas, the cost of running a wire-pair to customer premises sometimes runs to many thousands of dollars. Low subscription fees were, moreover, offered to all, regardless of an individual customer's ability to pay. To cover the costs of building and operating the network, regulators charged high rates for long-distance service and business service.
This pricing had some interesting and predictable economic consequences. One effect was to make phone service easy to get, but expensive to use. It was as if the government had decided that everyone should have high-quality automotive transport and so put a BMW in every garage, but paid for the cars by placing a very high tax on gasoline. Everyone has a nice car, but few can afford to drive far because gas is expensive. In telephony, access was cheap and high levels of subscriber penetration were achieved (above 90 percent), but long-distance calling was very expensive, with prices sometimes 60 to 80 percent above marginal costs.
A pricing regime that undercharges for one good by overcharging for another contains the seeds of its own destruction. Overcharges create a powerful profit incentive for new sellers to enter and supply the overpriced good at a lower price. Correspondingly, there is little incentive to enter and compete in a market in which the current producer undercharges for the good. Unless a potential entrant possesses superior skills or technology, actual entry would not be attractive.
Unsurprisingly, new telecommunications firms have entered in precisely those segments of the industry where prices are highest relative to costs of providing service. That is what happened historically in long-distance in the seventies. It is happening today in local telephone service as competitors using new technologies offer less expensive services to large corporate customers, who have traditionally paid disproportionately high rates for local service.
Competition has been highly salutary. It has forced a rebalancing of rates more in line with underlying costs, causing more economically optimal rates of usage. The gains in economic welfare from more efficient telecommunications pricing have been estimated to be on the order of several billion dollars a year. Economist John T. Wenders estimates the potential gains from a move to fully efficient pricing to be tens of billions of dollars annually. At the same time, because the relevant markets are so large, very small taxes on service could, in principle, generate substantial amounts of revenue to finance subsidies to the poor and maintain universal service.
Public Policy Issues
The traditional method of regulating telephone rates has been to set them on the basis of average costs, including a "fair" return on invested capital. Most economists are highly critical of this approach. Even if prices reflected costs, customers would not be well served if costs were inflated. Costs are likely to be inflated, because if prices are based on costs, managers of regulated monopolies know that they can charge higher prices by having higher costs. At the same time, limitations on the amount of profit that may be earned limit incentives to reduce costs in order to increase profitability.
Costs of providing different services and service to different customers often vary significantly. Therefore, average-cost pricing overcharges some customers (those who are cheap to serve) and undercharges others (those who are expensive to serve). This promotes inefficient rates of use, with the overcharged customers using too little and the undercharged customers using too much. Overcharges may also lead some customers to seek lower-priced alternatives that are actually more costly to provide. Suppose a customer who is confronted with a $15 price for a service that costs $10 to supply turns to an alternative that is priced at $14 but costs $12 to supply. The customer saves a dollar on each unit purchased, but the cost of each unit is $2 higher than it need be. Inefficient pricing may thus promote an artificial industry structure not based on genuine differences in costs or in service quality.
Regulation that requires cost-based pricing may also give the regulated firm an incentive to allocate costs toward markets in which customers are captive (i.e., lack alternatives) and away from markets in which customers have alternatives. In this way the firm may restrain competition in potentially competitive ancillary markets.
One solution to these difficulties is for regulators to break the link between prices and costs and adopt a simple system of price caps. This is what regulators in the United Kingdom and the United States have recently tried to do. Under price cap regulation the regulated firm's ability to raise its prices is proscribed, but it is allowed to keep any additional profit it can earn by reducing its costs or introducing new services. Regulators monitor service quality to ensure that service is not degraded, and periodically reset the price caps to capture part of any cost savings for consumers on a forward-going basis. Because prices do not depend on cost allocations, incentives to misallocate costs and inhibit competition are reduced.
This type of regulatory reform works only if the government can make a credible commitment to allow regulated firms to keep some of the profits from their economizing. If it cannot—if as soon as a company economizes or innovates, the government attempts to cut prices—no incentives are created, and no such efforts will be undertaken. As price cap proposals have made their way through the regulatory and political process, they have often come to resemble traditional forms of regulation, with the promised opportunities to earn additional profits becoming increasingly weak. Nevertheless, small improvements have occurred in some jurisdictions. As experience with new forms of incentive regulation accrues, prospects for additional reforms should become brighter.
Finally, it should be noted that, in many respects, the old Bell System was like a sovereign state. By virtue of its monopoly, it had the power to tax and use the proceeds to perform all sorts of traditionally governmental functions, including the funding of basic scientific research and the establishment of industry technical standards. One frequently expressed fear was that divestiture would make inadequate provision for these kinds of public goods.
Actual experience offers a mixed picture. Funding of telecommunications-related research has increased in real terms since divestiture, but much of this research is oriented toward commercial applications. Whether sufficient funds are being directed toward fundamental research, only time will tell. The standards issue also presents a mixed picture. On the one hand, standards-setting processes are now clearly more open and less subject to strategic manipulation than they were before divestiture. On the other hand, the government supply of legal process has proven to be almost infinitely elastic, while the government's ability to resolve standards issues in a timely fashion remains unproven.
John Haring is a principal of Strategic Policy Research, Inc. He was previously the chief economist at the Federal Communications Commission and chief of the commission's Office of Plans and Policy.
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