DRI-281 for week of 2-24-13: Our Telecommunications Marketplace: The Rest of the Story

An Access Advertising EconBrief:

Our Telecommunications Marketplace: The Rest of the Story

Last week’s EconBrief told the tale of the man who, with reasoned premeditation, set out to release the telecommunications marketplace from the thrall of natural monopoly. This week we counter with what the late Paul Harvey might have called “the rest of the story” – the complement to the policy revolution wrought by Tom Whitehead in the White House Office of Telecommunications Policy.

This is a different story altogether. The actions of the Federal Communications Commission (FCC) and the Department of Justice (DOJ) were triggered by the chance decision of one man. That man was not an economist or a free-market ideologue. He was a lawyer and bureaucrat motivated by helplessness and disgust with his task of regulating the Bell system. He sought only to inflict a pinprick – but ended up helping to topple the world’s largest corporation from its monopoly throne.

The key elements of the story were told by economic historian Peter Temin in his short essay, “The Primrose Path,” in Second Thoughts: Myths and Morals of U.S. Economic History, edited by Donald N. McCloskey.

Enter Bernie Strassburg

Bernie Strassburg was a lawyer who headed the FCC’s Common Carrier Bureau. He was charged with regulating telephone and telegraph companies; e.g., he rode regulatory herd on AT&T and Western Union.

In the early 1960s, AT&T was the world’s largest corporation. Federal law gave them a virtual monopoly on American telephone service, both at the local level and for long-distance service. But the monopoly also extended to telephone equipment as well; it as illegal to use any equipment not manufactured by Bell. Thus, the Bell system was vertically integrated.

Regulating them was like wrestling an octopus. Each of the Bell regional companies was regulated by the public-utility commissions (PUCs) within its service area. PUCs conducted hearings to determine the allowable “fair rate of return” on the utility’s rate base. This formed the basis for the rates charged by the company.

The word “rates” applies literally. Instead of charging one universal rate to all users, the Bells charged differential rates to different classes of users. Residential users got preferential low rates, thanks to the doctrine of “universal service.” Telephone service was deemed a necessity to health and safety reasons and the low rates were ostensibly necessary to make it affordable to low-income residents. Business users got special rates – special high rates, that is. After all, businesses could apparently afford to provide all kinds of non-salary benefits for employees, such as health insurance, pensions, retirement accounts, etc. Why not make businesses pay high rates for telephone service and use the proceeds to subsidize residential service?

Of course, economists know why not. This is precisely analogous to a tax on business, and no business ever paid a tax. Instead, the tax – or, in this case, the high charges for telephone use – are borne in the short run by owners and employees of firms driven out of business by the higher costs, as well as by consumers of goods produced using telephone services as an input. In the long run, all costs are borne by suppliers of inputs and/or consumers. In this case, that means consumers of goods that use telephone services in their production and suppliers of inputs to those industries. Too few of those goods are produced and too many resources are devoted to providing telephone services to residential consumers. Although residential consumers pay a lower prices for telephone services – at least temporarily – their real incomes are almost surely lower thanks to the smaller quantity of other goods and services they consume.

A crowning irony of the politically sacrosanct doctrine of universal service is that the penetration of telephone service never reached the levels reached by television. Apparently telephone service wasn’t as necessary as television service, no matter what regulators claimed.

Instead of high nominal profits, public-utility owners earned the equivalent of lower nominal profits at virtually zero risk. Utility managers earned high salaries, worked in plush offices and oversaw huge staffs. Utility executives substituted easy living and a quiet life for the go-go, big-profit lifestyle of corporate America. Well-off elderly Americans held AT&T and Bell regional stocks in their portfolios for risk-free high returns. And this cushy deal was safeguarded by Bell’s political activities. State and local rate regulation attracted Bell lobbyists like locusts to the legislative harvest. Lobbying costs were paid by ratepayers.

The Bell system’s equipment monopoly was just as stifling as its monopoly on phone service. Bell’s monopoly on phone service was reinforced by a prohibition on the conjunction of Bell and non-Bell equipment. Thus, use of competing answering machines, modems and telephones was barred if it involved interaction with Bell facilities. In the mid-1950s, DOJ filed an antitrust lawsuit against AT&T challenging the integrated company’s refusal to allow “private communication” on its network.

Bell’s response was that it was willing to provide such items for its customers. Indeed it was – at a price. Bell’s AT&T Long Lines company also provided long-distance service – at high rates that subsidized the system’s artificially low residential customer rates. It provided data transmission service to business – at prices so high that some businesses even incurred the expense of setting up their own two-way private networks between key locations. The issue wasn’t so much provision of service as its terms.

The Paradox of Natural Monopoly Regulation

The idea behind natural monopoly is that one single firm is the most efficient supplier for the entire market. Even if competition is allowed, the process will inevitably culminate in the victory of a single firm, and that firm will then proceed to establish the price and output of a pure monopolist. Because that price is so much higher and the rate of output so much less than would be “chosen” (in the aggregate) by a competitive industry of firms, government regulation intervenes to seek a preferable compromise. The efficiency of single-firm production is enjoyed, while the price and output outcomes of pure monopoly are moderated – not to the degree attained under competitive conditions, but enough to reward the firm’s owners with only a “normal profit.” That rate of profit is only just sufficient to attract the capital needed by the firm.

This compromise seemed superficially attractive. It avoided the disadvantages of the other popular public-utility model, adopted in Europe and Canada. Equating the public-utility price to its marginal cost would approximate the price and output result under competition. But public utilities often exhibit decreasing average costs of production for technological reasons such as the famous 2/3 Rule. When an average magnitude is falling, that means its corresponding marginal value is less than the average; the marginal is pulling the average down. If price is set equal to marginal cost, it must be less than average cost under decreasing cost conditions of production. When price is less than average cost, the firm is losing money. The European/Canadian model is feasible only when accompanied by large public subsidies to the public-utility firm. Meanwhile, all the same difficulties and expense of conducting rate cases and calculating the utility’s costs are still present.

In actual practice, the case of the Bell system exposed the gaping flaws in the U.S. version of natural monopoly regulation – indeed, in the very concept of natural monopoly itself. If regulation had established a single price for all users, it might have remained viable. But this would have exposed the true costs of providing phone service to the American public. It would have allowed them to judge whether the benefits of having a single integrated firm provide service to everybody were worth the drawbacks of excluding competitors and innovation from the market.

Government was not willing to tell the public the truth when a politically irresistible lie was within their grasp. By setting residential-consumer rates artificially low, it could pose as the public’s benefactor, the savior who rescued them from the clutches of the evil monopoly. Of course, regulators would then have to make good on their promise to the public utility’s owners by making up the lost revenue somewhere else. They did this by allowing the company to charge draconian prices to business and long-distance users. This won the votes of dreamers who liked to fantasize that non-human entities called “businesses” could pay taxes and lift the burden of high prices from ordinary people.

It is true that the public avoided the obvious ill effects of unregulated pure monopoly – a single high price, reduced output and above-normal profits. But all these same effects were realized in hidden form – monopoly prices paid by businesses and long-distance users, reduced output of private communications and goods using telephone services and risk-free profits and lifestyles enjoyed by public-utility owners, managers and employees.

While an unregulated monopolist doesn’t have to worry about regulation, he does have to worry about entry of competing firms. Of course, the theory of natural monopoly claims that firms won’t want to enter once the natural monopoly is attained. But in that case, why did the federal government constantly fend off the advances of firms wanting to compete with AT&T? This highlights the worst aspect of natural monopoly regulation – the strangling of incipient competition in its crib.

And this is where Bernie Strassburg came in.

The Pinprick

The 1956 DOJ lawsuit sought to restructure the Bell system along European lines by forcing divestiture of the Bell Operating Companies (the regional Bells) and equipment divisions (Western Electric and Bell Labs). Bell insisted on maintaining its integrated system. The Eisenhower administration asked the FCC if it could regulate the integrated system.

Speaking in his capacity as head of the Common Carrier Division, Strassburg drafted a memo in which he maintained that the FCC had the authority to regulate the entire Bell system but lacked the resources and expertise to do the job. Strassburg was reflecting on the reality of natural monopoly regulation as we have described it. But his bosses at FCC, thinking only of their own welfare, deleted the second part of his reply and submitted this edited memo to the Administration. Consequently, the Bell system’s position was accepted on the presumption that the federal government’s regulatory authority would suffice to protect the public welfare.

Now Strassburg was in a fix. He had been told to herd an unruly rogue elephant without being given as much as a stick to help with the job. In desperation, he cast about for any means of prodding the beast towards lowering costs (hence, prices) and accepting competition. First, he used the imminence of computer technology as an excuse to force acceptance of private devices as adjuncts to Bell technology. He was aided by the FCC’s decision in the Carterfone case, which forbade Bell’s prohibition of outside equipment on private lines.

Next, Strassburg considered the application of a tiny company with only 100 employees. The company was named MCI. It wanted to lease its microwave-tower facilities stretching from St. Louis to Chicago to private businesses for use in voice and date transmission via radio waves. Companies that could not afford to build their own internal network could lease MCI’s facilities more cheaply than they could purchase Bell’s expensive package of business services.

Microwave technology had been around since World War II. The FCC had already decided in 1959 that the Bell system did not own airwave rights to microwave radio transmissions. The question was: Could MCI meet the government standard of “convenience and necessity” required to get permission to enter the market?

There were countless businesses tired of paying through the nose for AT&T’s business service, even on this one route, so lining up prospective customers to testify in their behalf was easy. But MCI had to show a “need” for their service by proving that they were more efficient than Bell. It wasn’t enough that they could offer their customers a lower price – the government didn’t recognize that as sufficiently valuable to justify allowing competition.

MCI claimed that their microwave technology was more efficient than AT&T’s landline technology. AT&T countered that MCI was simply “skimming the cream” of AT&T’s business customers, who were paying AT&T’s monopoly price, without having to assume the burden of providing residential service to AT&T’s local customers. In a sense, AT&T was right, because the technological differences did not represent large differences in cost. But in the substantive economic sense, MCI was lined up on the side of economic efficiency and consumer welfare. MCI was breaking up the AT&T pattern of cross-subsidy between business and residential consumers, which was creating concealed monopoly inefficiencies and harming consumers on net balance.

Strassburg has no illusions that MCI would be able to compete effectively with powerful AT&T. As Peter Temin noted, all Strassburg wanted was a pin to prick the rogue elephant with, something to wake it up to the changing technological realities of the unfolding new age. So he supported MCI’s petition to operate. AT&T’s appeal was denied.

MCI Unleashed

In 1969, MCI was allowed into the market for microwave voice and date transmission. Its new CEO, venture capitalist William McGowan, didn’t waste a second. He knew that there were dozens of routes whose profit opportunities mimicked those of the St. Louis-Chicago corridor. So he created over 2000 MCI-affiliate companies whose applications flooded the FCC.

Bernie Strassburg abandoned all pretense of considering each individual application. In 1971, the FCC issued a general rulemaking approving microwave facilities that met general criteria for service.

In order to serve hundreds of different customers, MCI couldn’t contemplate building separate connection facilities with each one. Instead, MCI applied to interconnect with Bell’s facilities. By this time, AT&T could see the handwriting on the wall and knew that MCI was a genuine competitive threat. It refused MCI’s interconnection requests. MCI filed an antitrust action against AT&T in 1974 alongside the DOJ’s celebrated suit.

Also in 1974, MCI offered its own package of switched long-distance service. This marked a competitive milestone. In five years, MCI had gone from a piddling 100-employee firm with no revenue and one private-service route to a full-fledged competitor of the mighty AT&T.

This was too much even for the FCC, which opposed MCI’s petition to offer long-distance service. But the genie was out of the bottle now. Bernie Strassburg has unleashed the forces of competition and nothing could pen them back up again. By 1981, AT&T had to give up ownership of the Bell Operating Companies in exchange for the right to retain vertical integrated status. The Bell System as such was gone. The monopoly was broken.

During its corporate career, MCI developed important innovations. The company applied for the first common-carrier satellite license when the White House OTP’s “Open Skies” policy went into effect. It was the first telecommunications firm to install single-mode fiber-optic cable, which is the industry standard today. In the early 1980s, MCI developed an early version of electronic mail. And in the mid-80s, MCI worked with several universities to establish high-speed telecommunications links between their computer systems – a forerunner of the Internet.

The Rest of the Story

Bernie Strassburg’s story complements that of Tom Whitehead. The birth of our modern telecommunications marketplace was a miracle. Tom Whitehead intended the substitution of competition for monopoly but it was miraculous that he ever ascended to a position of sufficient power to effect it. Bernie Strassburg intended no such outcome as the birth of competitive telecommunications; all he ever wanted was to get more regulatory leverage over the Bell System. He never questioned the bona fides of the natural monopoly argument nor did he hope that MCI would ever compete successfully with AT&T.

The fact we needed a miracle to give us the manifest blessings of cell phones, digital technology, I phones, smart phones, cable telephony and streaming Internet is profoundly disturbing. In a competitive environment, the fact that any particular firm succeeds as Microsoft or Apple has may be amazing but the fact that some firm does is no miracle at all; it is what we justifiably expect. But regulation gave us plodding, inefficient, complacent monopoly for decades; the fact that competition eventually triumphed over it was a miraculous accident.

Nor did it have to happen this way. The well-known industrial organization economist Harold Demsetz pointed out some four decades ago that regulated monopoly is not natural, necessary or inevitable. Even if there is no competition in the market, firms can still compete for the market. That is, we could have put up the right to operate as a monopolist in a public-utility market for competitive bids. In effect, firms could bid by committing to the price and quantity targets they would subsequently meet, with the best bid winning the contract. In this way, the bidding process itself would be the check on monopoly power. If there were enough bidders, we would expect the outcome to approximate that of a competitive process.

In his book Capitalism and Freedom, Milton Friedman pondered the possibilities under so-called “natural monopoly” conditions. He concluded that unregulated monopoly is preferable to regulated monopoly. The history of public-utility regulation vindicates Friedman’s position. The defects of hidden monopoly under regulation outweigh those of straightforward monopoly.

Today, the concept of natural monopoly is laughable when applied to the telecommunications marketplace because technological innovation proceeds so quickly that it offsets any temporary effects of monopoly power. Today’s “monopolist” is tomorrow’s has-been; a downward-sloping cost curve cannot compete with a downward-shifting cost curve.

Instead of relying on regulation to produce these miracles, it is long past time to reform it or eliminate it altogether.