DRI-293 for week of 2-17-13: The Man Who Created Today’s Telecommunications Marketplace

An Access Advertising EconBrief:

The Man Who Created Today’s Telecommunications Marketplace

Today we live in a world enveloped by telecommunications. I-phones and Smart-phones provide not only voice communications but data and Internet transmission as well. Cell phones are ubiquitous. Television stations number in the hundreds; their signals are received by consumers in direct broadcast, cable and satellite transmission form. Both radio and TV broadcasts can be streamed over the Internet. The Internet itself is accessible not only using a desktop computer but also via laptops, Wi-Fi and mobile devices.

For anyone below the age of forty, it strains the imagination to envision a world without this all-encompassing marketplace. Yet older inhabitants of the planet can recall a starkly primitive telecommunications habitat. In the United States – the most technologically advanced nation on Earth – there was one telephone company for almost all residents in 1970. There was one satellite transmission provider. In the wildly competitive corner of telecommunications – broadcast television – there were three fiercely competing networks.

How did we get from there to here in forty short years? And can we entertain an alternate scenario in which we might not have made the journey at all? The answers to these questions are chilling, for they open up the possibility that were it not for the efforts of one man, the great revolution in telecommunications might not have happened.

The man who created the telecommunications marketplace of today was Clay “Tom” Whitehead. The unfamiliarity of that name is an index of why we should study the unfolding of competition in the market for telecommunications. Before we introduce the leading character in that drama, we first set the scene by describing the terrain of the market in 1970 – and what shaped it.

The Economic Doctrine of Natural Monopoly

In 1970, American Telephone and Telegraph – the corporate descendant of the Bell Telephone Company founded by Alexander Graham Bell – was the monopoly telephone service provider for virtually all of America. The rationale for this arrangement was provided by the doctrine of natural monopoly.

A natural monopoly was said to exist when a single firm was the most efficient supplier for the entire market. This was caused by the unique cost structure of that market, in which the average cost of production decreased as output increased. It is vital to visualize this as a static condition, not a dynamic one; it is not dependent on a succession of technological innovations of the sort for which Bell’s scientists were renowned. If Bell Labs had never developed a single invention, in other words, the company’s status as a natural monopoly would not have changed.

If decreasing average cost was not due to innovation, what did cause it? The most plausible explanation came from engineering. The 2/3 Rule related the productivity of transmission through a pipe or transportation via a container to its cost. But since its cost increased as the square of surface area while its productivity or throughput increased as the cube of its volume, the average cost or ratio of total cost to total output continually fell as output increased because productivity (in the denominator) increased faster than cost (in the numerator).

Continually falling average cost meant that one firm could constantly lower its price while producing ever more output, while still covering all its costs. This would enable it to underprice and force out any and all competitors. Since monopoly was the eventual fate of the industry anyway, better to relax and enjoy it by declaring a monopolist while striving to mitigate the monopoly outcome.

In America, the mitigation was accomplished by profit regulation. The natural monopoly firm was allowed to earn a “normal” rate of return, sufficient to attract capital to the industry, but no higher. That normal rate of profit was identified by the public utility commission (PUC) based on hearings at which the company, regulators and various interest groups (notably regulators supposedly representing consumers) testified.

When outlined in textbooks and classrooms, this concept sounded surprisingly reasonable. When put into practice, though, it was a mess.

Perhaps the worst feature of PUC-regulation of so-called natural monopoly was the increasing chumminess between commissions and the monopoly firms they oversaw. This sounds like an accusation of collusion, but in reality is was the inevitable by-product of the system. Commissions lacked the technical expertise to regulate a high-tech business. While they possessed both the right and the ability to hire consultants to advise them, trouble and expense relegated this to rate-case hearings at which the profits and rates charged by the company were reviewed. On a day-to-day basis, the commission was forced to cooperate with and rely on the company’s employees to guarantee that the utility’s customers were served.

After all, the firm was a genuine, honest-to-goodness monopoly – not a phony, pseudo-monopoly like the oil companies, which faced scads of competition and any one of whose customers had lots of competitive alternatives to turn to. The oil companies were monopolies only for purposes of political theater, when politicians needed a scapegoat for their foolish energy policies. But if a public utility were threatened with insolvency or operational failure, then the lights might go out or the phones go dead for an entire city, metro area or region. So the PUC was regulating and utility and protecting it at the same time.

Regulation was probably an impossible task anyway, but this ambiguity made things hopeless. The result was that PUCs erred on the side of excessive rates of return and compliance with company wishes. Since high profits were out of the question anyway, public-utility executives took their “excess profits” in the form of perquisites and a quiet life, free from the stresses and strains of ordinary business. Public utilities became noted for lavish facilities, huge administrative budgets and large staffs – in the vernacular of the industry, this was called “gold-plating the rate base.” (The rate base was the agreed-upon list of expenses and investment the company was allowed to recover in rates charged to customers and upon which its rate of return was earned.)

Ordinary businesses feel constant pressure to hold down costs in order to maximize profit; cost-minimization is what helps insure that scarce economic resources are used efficiently to produce output. But public utilities were assured of their profit and coddled by regulators; thus, they faced no pressure to reduce costs or innovate. Indeed, the reverse was true – a cost innovation would theoretically call for new rate hearings to reduce the utility’s rates, since otherwise it would exceed its regulatory allowance of profit. Economists were so fed up with the sluggish pace of technological progress among public utilities in general, and the Bell system in particular, that most viewed the phenomenon of “regulatory lag” as a good thing. It was worth it, they reasoned, for the utility’s profits to exceed its limit in the short run as an inducement to effect cost reductions that would achieve long-run efficiency.

It would seem that PUCs would have faced public criticism for failure to hold down public-utility profits, since that was their primary raison d’être. Commissions sought to inoculate themselves from this criticism by a policy of offering artificially low prices to residential customers of public utilities. Since they had to raise enough total revenue to meet all utility costs plus an allowance for a fat profit, this subsidy to residential customers had to be recouped somewhere. In practice, it was regained by socking business users with onerous rates. The Bell phone companies, for example, charged notoriously high rates to business users of telephone service.

Commissions trotted out a legal rationale for this policy of price discrimination in favor of residential users and against business users. The policy furthered the goal of universal service, claimed commissioners proudly. Because public-utility products were goods like telephone service, electric power and gas service, commissions could plausibly depict them as necessary to public health and safety. Consequently, they justified subsidies to residential users by maintaining the necessity of assuring service to all, regardless of income, on the basis of need.

Of course, the economic logic behind the policy of universal service was non-existent. High rates levied on businesses were not paid by non-human entities called “businesses.” No business ever paid anything in the true economic sense because payment implies a sacrifice of alternative consumption and the utility or happiness delivered by it. Since a business cannot experience happiness – or lose it – a business cannot pay for anything. Those high business rates for phone service, for example, were paid in the long run by consumers of the business’s output in the form of higher prices and by suppliers of inputs to the business in the form of lower remuneration. But to the extent that the public were deceived by the rhetoric of the commission, they may have approved the wasteful doctrine of universal service. This is ironic, for the Bell system never succeeded in increasing the percentage of household subscriptions to phone service to the level of the percentage of households owning a television set. So much for the absolute necessity of telephone ownership!

Meanwhile, public utilities became public menaces when they spotted businesses threatening their turf. Cellular telephone technology was technically feasible as long ago as 1946 (!), but the Bell companies weren’t interested in developing it because they already had a highly profitable and completely secure fiefdom based on landline technology. And they weren’t about to stand idly by while other businesses moved in on their markets! Consequently, applicants for licenses to operate mobile phone businesses were either denied or hamstrung by red tape.

In 1956, the Justice Department was sufficiently fed up with Bell’s antics to launch an antitrust suit against the Bell system. In a sense, this was inherently contradictory since government had granted the monopolies under which the Bell companies operated. But Justice accurately realized that something had to be done to break up the cozy arrangement between Bell and the state and local politicians whose regulation was in fact serving as the barrier to competition in products ancillary to Bell’s landline phone service. It is one measure of the political influence wielded by the Bell empire that this lawsuit proved abortive and was dropped without result.

Another indicator of Bell’s power was the fact that the Bell companies annually issued more debt than did the federal government itself. When the federal antitrust action was revived in 1974, then-Secretary of State George Schultz (formerly a well-known labor economist at the free-market oriented University of Chicago) reminded prosecutors of this fact and advised that the antitrust suit be quashed for fear of “roiling the bond markets” prior to an upcoming bond issue by the U.S. Treasury. This advisory outraged a relatively obscure White House official at the Office of Technology Policy.

Tom Whitehead and the “Open Skies” Policy

In 1970, Clay T. “Tom” Whitehead was a young (32) graduate engineer whose life had taken a detour when he was introduced to economics. He followed up his Master’s in electrical engineering at MIT with a PhD in economics there, studying under noted scholar, theorist and consultant Paul MacEvoy. When the Nixon administration inaugurated the position of White House Office of Telecommunications Policy, Whitehead’s academic credentials and connection to MacEvoy earned him the post of Director. President Nixon viewed the subject of economics with ill-concealed disdain; his aides envisioned the job as a way of grabbing countervailing policymaking power away from the permanent regulatory bureaucracy that controlled the federal government and was dominated by Democrat appointees. Little did they know what kind of policymaker they were getting.

The moon landing in 1969 had achieved the objective of NASA’s space program, which was left with no immediate goal in sight. The Vietnam War had become a fiscal burden as well as a political one, and there was talk of enlisting the private sector to carry some of the financial freight by sponsoring a communications satellite. Up to that point, the satellite program (COMSAT) had been a de facto joint creature of the federal government and AT&T. NASA produced the satellites, the best-known being Telstar. AT&T owned a plurality of the stock shares and seats on the board of directors.

The chairman of the Federal Communications Commission (FCC), a Republican, drafted a proposal for a fully privatized company. It was to be a joint monopoly to be shared by NBC, ABC, CBS, RCA, GTE (a Bell company) and AT&T. The presumption was that satellite communications was a natural monopoly like all other forms of communications – television and radio networks, telephone and telegraph. There was no point in promoting a competitive process that was bound to culminate in a monopoly.

Tom Whitehead begged to differ. He put forward a radically different proposal called the “Open Skies” policy. There was plenty of room in space for many satellites owned by many different private companies, each serving their own interests and customers. There was plenty of bandwidth available for satellites utilize in receiving signals and transmitting them back to Earth. All that was necessary was to adjust orbits and frequencies to preclude collisions and confusion – something that all parties had an interest in doing.

Practically everybody thought Whitehead was crazy. The ones who didn’t doubt him feared him because he threatened their economic or political predominance. But he had the backing of the White House, not for ideological reasons but because he opposed the Establishment, which hated Richard Nixon. And he won his point.

One by one, private firms began sending up communications satellites into space. First came Western Union in 1974. Then came RCA in 1975, followed by Hughes and GTE. The first half-dozen were the pioneers. Eventually, the trickle became a deluge. And the modern age of telecommunications was born.

Privatization of satellite communications also stimulated competition in, and with, cable television. Cable TV had previously been strictly a local phenomenon, tied to AT&T by the need to lease coaxial cable facilities and rights of way. Whitehead approved FCC 1972 policy proposing to loosen federal regulations on cable. In 1974, he chaired a committee whose report advocated federal deregulation of cable. This freed the industry to lease and own satellites and take its product national. Satellite communications allowed competing cable providers uplink popular local and regional stations’ programming to satellite for national distribution. Later, satellite TV emerged as a leading competitor to cable TV, providing more channels, better reception and fewer problems.

More recently, satellite radio and TV have developed their own competitive niches. Satellites have become the transmission media of choice for telecommunications, establishing a transmission position of advantage from which signals could be sent throughout the planet. This revolution was the brainchild of Tom Whitehead.

Tom Whitehead and the Breakup of AT&T

Tom Whitehead did not initiate the antitrust suit against AT&T, nor was he directly involved in prosecuting it. But he was a powerful influence behind it nonetheless.

His staff at OTP had independently reached the conclusion that the political power and economic inertia of the Bell system formed an insuperable obstacle to competition in telecommunications. When he urged them to approach the Department of Justice about reactivating its 1956 suit against Bell, they learned that DOJ was moving in that direction already.

Had the White House opposed this initiative, it would have stalled out like its predecessor. The Department of Defense claimed that the lawsuit was a threat to national security because the Bell system was a vital cog in the national defense. (Among other things, AT&T worked closely with DOD, the Pentagon and the FBI on civil defense, counter-espionage and domestic military exercises.) As noted above, AT&T even wielded financial clout in government circles because its capital-intensive production methods made it even more heavily reliant on debt finance than the federal government itself.

But Whitehead was adamantly in favor of the action. The American public complained about the absurdity of fixing a phone system that wasn’t broke and compared the suit to a parallel action against IBM. In fact, the two had nothing in common, since IBM wasn’t a monopoly while AT&T was a monopoly in the old-time, classical sense – it was not only a single seller of a good with no close substitutes, but entry into its market was legally barred by the government itself.

The regional Bell companies resisted the breakup tenaciously and still to this day continue to fight harder against competition than they do commercially against their competitive rivals. After all, they were created as creatures of regulation, not competition, and don’t really know how to behave in a competitive market.

The result speaks for itself. Today, Americans have decisively rejected landline telephone service and embraced the new world of wireless and digitized telecommunications. They can obtain phone service via cell phones or more sophisticated mobile devices that perform multiple functions. They can combine phone service with data processing functions over the Internet. The last vestiges of the old monopoly remain standing alongside the dying Post Office in the form of mandatory service provided to remote and rural areas. Today, even the staunchest defenders of regulation and the old status quo cannot deny that Whitehead was the visionary and that they were the reactionaries.

Whitehead’s Subsequent Career

After leaving OTP in 1974, Tom Whitehead went first to a subdivision of Hughes Communications, where he started a private cable division. He thus became instrumental in what later became the development of satellite TV. Then he fomented his next revolution by moving to Luxembourg (!), where he started SES Astra, a satellite company that pioneering private television broadcasting in Europe. Before Whitehead, Europe had no private television broadcasters; they were all state-owned.

Luxembourg was chosen because its miniscule size allowed Whitehead and company to chainsaw their way through its government bureaucracy relatively quickly. The nature of their opposition can be gauged by the fact that they faced their first lawsuit within 20 minutes of receiving their incorporation papers. Today, the company Whitehead founded is the world’s second-largest satellite provider, riding herd on more than 50 satellites that serve over 120 million customers.

After retiring, Whitehead taught at GeorgeMasonUniversity where he hosted the world’s leading figures in telecommunications at his seminar. He died in 2008. This year, the Library of Congress received his papers. The American Enterprise Institute commemorated the occasion by organizing a symposium of his friends and co-workers to highlight his role in shaping the world we inhabit.

The Economic Significance of Tom Whitehead

Tom Whitehead’s life starkly defines the importance of individuals to history and human welfare. Only a tiny handful of other human beings on the planet might have occupied his position and achieved the outcomes he did. And without those outcomes, the world would be a vastly different – and far worse – place.

Tom Whitehead was fought tooth and claw by the forces of government regulation. (The historical chain of coincidence that lined up DOJ against AT&T will be the subject of a future EconBrief.) This illustrates the fact that government regulation of business is not a useful supplement to marketplace competition, but rather an inferior substitute for it. The purported aims of regulators are in fact precisely the outcomes toward which competitive markets gravitate. If regulators knew better than businesspeople and consumers how to produce, sell and select appropriate numbers and kinds of goods and services, they would work in the private sector rather than in government. Their position in government places them poorly to run companies or industries, or to impose their will on consumers. In this case, if regulators had their way, we would still occupy the telecommunications equivalent of the Stone Age.

Whitehead’s life illustrated the difference between technological progress and economic progress. Communications satellites became technically possible in the late 1950s; cell phones in the mid-1940s; cable TV in the 1930s. But these did not become economically feasible until the 1970s. And economic feasibility, not technical or engineering feasibility, determines value to humanity.

Economic feasibility requires demand – a use must be found that delivers value to consumers. It requires supply – the technically-feasible product or process must be produced and sold at a sacrifice of alternative output that consumers can accept. Last, but not to be overlooked, the technically feasible product or process must be politically tolerated. Incredible as it might seem, this last hurdle is often the highest.

Tom Whitehead played a direct role in meeting two of these requirements for telecommunications and indirectly allowed the third to be met. He created the telecommunications market we enjoy today as surely as did Edison, Tesla and the technological pioneers of the past.

His name should not languish in obscurity.

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