DRI-168 for week of 5-17-15: Who Killed the Amtrak 8?

An Access Advertising EconBrief: 

Who Killed the Amtrak 8?

At 9:21 PM on Tuesday, May 12, 2015, Amtrak Northeast Regional passenger train 188 was proceeding northeast en route from Washington, D.C. to New York City. Specifically, it was traveling through Philadelphia a few miles north of 30th Street station in an area called Frankford Junction. Passing through a short stretch of eastbound track, it came to a fairly sharp northeast curve. The speed limit for a train entering the curve was 50 mph. According to the train’s “black box,” or data recorder, it was traveling at 106 mph as it entered the curve. The train’s engineer apparently applied emergency brakes immediately after reaching the curve, but a few seconds later – the point at which the data recorder stopped receiving data – the train had slowed only to 102 mph.

The reason the data recorder ceased operations was that the train derailed at that point. Seven people were killed at the crash site and one died subsequently; around thirty others were hospitalized with injuries of varying severity. The dead included the CEO of a technology firm and a naval-academy midshipman.

Reactions were predictable. Philadelphia Mayor Michael Nutter solemnly, somberly lamented the tragedy. Federal-government regulators stressed the desirability of transportation safety and passage of time necessary to decelerate a train. And, most predictable of all, politicians and political commentators placed blame on their political opponents.

Murdering Republicans Strike Again

An activist liberal policy group called “Agenda Project Action Fund” made a video giving their version of the events leading up to and including the derailment. It was titled “Republican Cuts Kill Again.” The “cuts” referred to were budget cuts by the U.S. Congress, a majority of whose members are currently Republican. An author named Josh Israel of “Think Progress” wrote an article titled “Currently Available Technology May Have Prevented Fatal Amtrak Crash, But Congress Never Funded It.” Politico.com chipped in with the headline “House panel votes to cut Amtrak budget hours after deadly crash.” Rep. Nita Lowey sententiously volunteered that “starving rail of funding will not enable safer train travel” – without, of course, mentioning that the combined federal and state Amtrak budgets have increased every year since 2008.

The immediate questions that arise are: What is this “currently available technology?” Why didn’t Congress fund it? But that doesn’t begin to exhaust the relevant sources of curiosity. How long has the technology been available? Why is Congressional funding even an issue in the first place, since Amtrak is nominally a for-profit corporation? Most importantly of all, what is the optimal framework for providing transportation services in general and passenger-rail services in particular – and how does Amtrak fit into that framework?

What is Amtrak and Why are People Saying These Terrible Things About It?

“Amtrak” is a hybrid name for the National Railroad Passenger Corporation. It is one of those centaur-like organizations common to modern big government – a nominally for-profit corporation that is nevertheless publicly funded. It receives annual appropriations from the federal government that have averaged around $1.4 billion in recent years. It also receives annual funding from various state-level sources, particularly about 14 state governments and the three largest Canadian provinces.

Amtrak serves 46 U.S. states and those three Canadian provinces. But the bulk of its business is provided in what is called the “Northeast Corridor” of the U.S. Although Amtrak’s routes comprise over 500 destinations, more than two-thirds of its nearly 31 million passengers come from the ten largest metropolitan areas in the U.S.; 83% travel routes of less than 400 miles.

Amtrak began operations on May 1, 1971. Today it runs over 300 trains per day across 21,000 miles of track. It has over $2 billion in annual revenue. But it has yet to turn a profit. It has always required subsidies. During the Reagan administration, these subsidies hit an annual low of $600 million before rising again subsequently. They have waxed and waned, but state-level subsidies have recently tended to compensate for cuts at the federal level. Government has also provided capital subsidies for investment; this explains why the left wing can call for Congress to fund safety improvements.

Although Congress provided limited authorization for Amtrak to deviate from labor-union agreements in the late 1990s, Amtrak has long employed union labor. It negotiates with 14 separate unions and has 24 separate agreements with those unions. For many decades under federal regulation by the ICC, the railroad business was a classic case of “featherbedding,” or the employment of superfluous workers in union-protected jobs. This remains true today with Amtrak. It is no coincidence that Amtrak’s national headquarters is Washington, D.C.

Amtrak is a lightning rod for political controversy. The left wing loves it because mass transit is a sacred cow of both the old left and environmentalists. The fact that Amtrak is horrendously inefficient is politically advantageous to the left because it means that it employs more labor than necessary to produce a given output – the very thing that outrages any competent economist delights the left wing.

It is true that left-wingers cite cost comparisons claiming that train travel is the most efficient form of passenger transportation. Unfortunately for their argument, the comparisons are bogus. They use “on-time” as a criterion for comparing airlines and trains while rigging the definitions to allow trains absurd margins of lateness. Even more telling is the fact that they completely ignore the element of consumer demand. The reason most people do not ride trains is the same reason that they prefer to drive automobiles – cars provide point-to-point transportation and maximum personal convenience. This economizes on the value of an individual’s time. Since we are all mortal and have limited hours in the day and in our lifetime, this is a vast benefit to us. But this is completely ignored in the cost comparisons claiming superiority for train travel. When economists conduct the comparisons and account for human time preference, this claimed superiority for mass transit vanishes.

The right wing hates Amtrak, but that doesn’t mean that it is unpopular with Republicans. Amtrak is popular in the most populous parts of the country, which means that most of the geographic U.S. (but a minority of the population) is subsidizing a relatively small part of the country (but a majority of the population). Consequently, Republicans – most of whom have the political backbone of invertebrates – tend to support subsidies. (This is particularly true in the House of Representatives, which is based on population.) How else have they continued, year after year after year? Instead of cutting Amtrak loose or voting for privatization, Republicans content themselves with rhetorical volleys against it and cosmetic measures designed to “make it work better.”

The “Currently Available Technology”

The “currently available technology” referred to by the liberal activist group is the Positive Train Control (PTC) system. It uses a combination of radio signals and GPS technology to pinpoint the position of all trains. Not only can slow speeding trains, it can also prevent collisions between trains, prevent trains from proceeding through wrongly positioned switches and prevent trains from entering work zones. In other words, PTC is an all- (or at least, multi-)purpose train safety system.

In 2008, Amtrak suffered a derailment in California with loss of life. Senator Dianne Feinstein (D-Cal), one of the most powerful Senate Democrats, did not let this crisis go to waste. She seized the chance to push through legislation mandating full installation of PTS for both passenger and freight railroad systems in the U.S. by 2015.

So what, many readers are doubtless thinking to themselves? Isn’t that the way the system is supposed to work? Isn’t this a victory for big government, the regulatory state?

Not hardly. Just the opposite, in fact.

Why PTS Is DOA

To an economist, the first thing that pops into mind is the question: If PTC is the greatest thing since sliced bread, why does Congress have to mandate its adoption? After all, freight railroads have been an extremely successful industry for years. Those ads touting their success in squeezing efficiency from train fuel are not hyperbole. Warren Buffett didn’t buy Burlington Northern because he thought its management was brain-dead. Why in the world wouldn’t the industry rush to adopt PTC if it were the last word in safety, since safety is vital to any successful freight operation?

The answer to that question was provided by the Reason Foundation. Thanks to the expertise of its founder, Robert Poole, the Foundation has long been recognized as the ranking expert in transportation. Policy analyst Baruch Feigenbaum gave his readers the lowdown on PTC.

The Federal Railroad Administration performed a cost-benefit study on PTC technology. It found a projected benefit range (discounted present value) of $0-$400 million. But the cost was $13 billion. Whoops. That means that for every $1 of (maximum) benefit, it cost $20 to install.

But because Congress, in its infinite wisdom, forced both passenger and freight railroads to install it, the entire railroad business has been laboriously slaving away at it for the last seven years. Of course, nobody is too crazy about throwing money down this rathole. The use of radio signals requires coordination with the FCC, and Amtrak, which can’t even coordinate with itself well enough to make a profit, is finding that difficult. Then there are the various regulatory hurdles. Yes, that’s right – the same government which has legislatively mandated the adoption of PTC is throwing up regulatory hurdles to it in the form of environmental and historic-preservation review for each of the 20,000 required communications antennas in the system. This has led to a year-long moratorium on installation, according to Association of American Railroads’ CEO Edward Hamberger in a Wall Street Journal op-ed.

But..uh, well, at least PTC is better than nothing, right? Wouldn’t we be stuck with no safety at all if we hadn’t passed that unbelievably dumb, wildly wasteful law? Apparently that’s what the political left wants us to believe; that is its intellectual fall-back position when confronted with the facts about PTC. Presumably, that is as far as the average person’s thinking goes on the subject.

But the inherent meaning of cost-benefit analysis is that “cost” refers to foregone alternatives. When cost exceeds benefit, there are better, more beneficial ways of spending the money than on the project being analyzed because the foregone alternatives represent benefits available elsewhere.

And in this particular case, some of those benefits are alternative safety projects within the railroad industry itself.

ATC – A Better, Lower-Cost Alternative

Both Feigenbaum and Hamberger describe another type of railroad safety technology now in use. Amtrak and freight railroads currently utilize a type of safety technology that relates specifically to speeding trains. It is called “Automatic Train Control” (ATC). It is installed on the tracks and sends signals to trains telling them what the speed limit is, allowing the train to automatically slow itself before reaching the speed-change point. In short, it is a mechanism for eliminating the particular type of human (engineer) error apparently responsible for the Philadelphia derailment. It would have prevented the Philadelphia accident.

It is quite true that ATC handles only this particular type of error; it lacks the all-encompassing scope of PTC. But ATC has the advantage of being relatively cheap and easy to install. We know this because after the recent Philadelphia derailment, Amtrak quietly installed ATC on the section of track where the accident occurred. It accomplished the installation in one weekend.

Nor is this the only type of alternative safety improvement to ponder. Marc Scribner of the Competitive Enterprise Institute recently noted that about 270 people die every year in accidents at train crossings. Why not take some of that $13 billion and devote it instead to improving crossing safety in various low-cost ways, thereby saving dozens of lives every year instead of 8-10 lives every 7 years or so?

Both Amtrak and private freight railroads have installed ATC. Why haven’t they completed that installation? Well, they both labor under the burden of meeting mandatory legal deadlines for which they will eventually be fined when 2015 expires without completion of the PTC system. Hamberger estimates 2018 as the PTC completion date, with another two years necessary for “testing and validation.”

Who Killed the Amtrak 8? 

Given the facts as outlined above, it is obvious who killed the Amtrak 8. Big government and the regulatory state killed them. Even Amtrak might have had the corporate brains to install ATC throughout the Northeast Corridor – by far its biggest revenue generator and arguably profitable in its own right – were it not faced with the overwhelming burden of having to install PTC.

This verdict is seconded by Wall Street Journal columnist Holman Jenkins in his latest column (WSJ, 05/20/2015, “How Congress Railroaded the Railroads”). “Is there a more absurd technology than positive train control, which Congress imposed as an unfunded mandate on railroads in 2008, and which supposedly would have prevented last week’s Philly Amtrak crash? Except it didn’t since its implementation has been draggy and its design so clearly inferior to cheaper, faster, more up-to-date solutions.”

Even beyond this, though, is the decisive point relating to the fate of passenger rail had big government not established and continually sustained Amtrak in the first place.

A World Without Amtrak

When Lyndon Johnson succeeded John F. Kennedy in the White House, he recognized that Kennedy’s assassination had created an extraordinary mandate for change. Johnson was perhaps the century’s premier legislative spearhead, and he essentially created the regulatory welfare state that presides over the country today. Johnson predicted that it would take 50 years to determine the success or failure of his “experiment” in social policy. A half-century later, we can deliver the verdict that the welfare state is imploding not just in the U.S., but worldwide.

Similarly, forty-four years should be sufficient to pronounce Amtrak a failure. Its infrastructure is ramshackle, its finances are a mess and its organization is a shambles. Amtrak’s only positive feature is a core constituency that leaves open the possibility of a profitable passenger rail service. That constituency, in the “Northeast Corridor” of America, boasts a population density roughly ten times greater than the rest of the U.S. This makes it possible for a for-profit, private-sector business to identify and isolate this customer base. In no sense is passenger-rail service a “public good” in the classical economic sense; it is neither non-exclusive nor non-rival.

Thus, the obvious solution to the problems plaguing Amtrak, of which safety is merely the one occupying front-pages currently, is to end its public subsidies, acknowledge its bankruptcy and sell off its assets. This includes its rights of way, which would enable a privatized successor to operate passenger rail for the benefit of the large number of people in the relatively confined area where that business is economically feasible.

To be fair, it should be noted that some are skeptical of privatization not on principle but as a practical matter. Like Holman Jenkins of The Wall Street Journal, they think the profits of the Northeast Corridor are overestimated and costs of service underestimated. Variable costs should take into account incremental wear and tear on infrastructure, which are now obscured by capital subsidies. Congress has given Amtrak preferential right-of-way over freight traffic on lines owned by the freight railroads – another implicit subsidy that would vanish under privatization. Various regional commuter transporters now tacitly agree not to compete with Amtrak, which is still another hidden subsidy. Could a privatized rail carrier still serve the Northeast Corridor without these subsidies? The only way to know is to try it and see.

To be workable, privatization would demand relief from the killing mandate currently crippling Amtrak and greatly hindering freight railroads – namely, the 2008 law mandating the adoption of the already-obsolete and dreadfully expensive PTC. This would save hundreds, if not thousands of lives, and improve life for millions of people. The only losers would be regulators, politicians and, possibly, union members who would lose jobs and be forced to take lower-paying ones. The union members could be bought off through severance. The others would simply have to eat their losses. In fact, this is increasingly the choice that confronts us not merely in passenger rail but in the entire transportation system.

As things stand today, the American transportation system is a massive form of human sacrifice to the gods of government regulation and unionization. Tens of thousands of Americans lose their lives every year so that government regulators and union members can hold their jobs and earn more money than would otherwise be the case.

Let us hear from Holman Jenkins again: “Which brings us to another headline from the brave new world of self-driving vehicles. This month the truck maker Freightliner introduced a robotically controlled truck, licensed to operate on the roads of Nevada. Its onboard system, designed to relieve drivers of the monotony of motoring for hours down calm stretches of well-marked interstate, ‘never gets tired. It never gets distracted. It’s always at 100%,’ company executive Wolfgang Bernhard told the media.”

“Alas, Mr. Bernhard deflated expectations by predicting that, though the system is ready to roll today, deployment is likely five years off. ‘The biggest obstacle that we see is the regulatory framework'” [emphasis added].

“Five years may be optimistic: An unspoken burden for the future is the legacy of the Toyota travesty of 2010, in which congressmen and, most damningly, a head of the Transportation Department, whose agency knows better, preferred to allege an undetected electronic bug in Toyotas rather than acknowledge that drivers (i.e., voters) cause accidents by pressing the gas instead of the brake.”

“This scandal, hugely costly to Toyota and largely fabricated, has never been acknowledged or investigated by the government of the media…One big inconvenient precedent lies in its wake. As Toyota found, because it’s impossible to prove the nonexistence of a software bug, anytime there’s an accident involving a system in which software plays a role, the software will be blamed and the driver will be excused. Perhaps the only way forward, then, is to remove the driver altogether” [emphasis added].

Whether it is cars, planes or trains, the dirty little secret that nobody is willing to talk about is the driver – the source of almost all the deaths and injuries. Here we have a train traveling at 106 mph in a 50 mph zone and an engineer with a case of amnesia. Sure, there was a dent in the windshield and talk of a projectile. But the dent didn’t penetrate the windshield and there is no logical explanation for how a projectile would cause the train’s speed to double. Is a left-wing lawyer going to emerge claiming that the train’s engine was manufactured by Toyota? Or are we eventually going to wind up with “driver error” as the cause of the derailment? Once again, with trains as with planes and cars, self-driving is the ultimate way forward.

Holman Jenkins is now acknowledging what this space declared over two years ago with respect to self-driving cars and almost a year ago with respect to commercial aviation. Now the same chickens are roosting on the tracks of passenger rail. Big government and regulators are standing athwart technology and yelling “Stop!” while over 30,000 people are killed every year on the nation’s roads, hundreds die in each commercial air crash and hundreds more die annually in various forms of railroad accident.

Up to now, none dare call it murder. Yet Democrats get away with accusing Republicans of murder for the sin of holding a Congressional majority.

DRI-326 for week of 9-1-13: Quantity vs. Quality in Economists

An Access Advertising EconBrief:

Quantity vs. Quality in Economists

Students of economics have long complained that economics texts focus too much on quantity and not enough on quality when evaluating goods. The same issue arises when comparing economists themselves. The career of Nobel Laureate Ronald Coase, who died this week at age 102, is a polar case.

Economists advance by publishing articles in prestigious, peer-reviewed journals. The all-time leader in the number of articles published is the late Harry G. Johnson. Despite dying young at age 53, Johnson compiled the staggering total of 526 published articles during his lifetime.

The use of advanced mathematics and abstract modeling techniques has enabled economists to rack up impressive publications scores by introducing slight mathematical refinements that add little to the substantive meaning or practical value of their achievement. When asked to account for the comparative modesty of a list of publications only one-fourth the size of Johnson’s, Nobel Laureate George Stigler countered, “Yeah, but mine are all different.”

Coase stands at the other extreme. His complete list of articles numbers fewer than twenty, but two of those are among the most-frequently consulted by economists, lawyers and other specialists, not to mention by the general public. He published a long-awaited, widely noticed book in 2012 despite having passed his centenary the year before. His life is an advertisement for the value of quality over quantity in an economist.

Another notable aspect of Coase’s work is its accessibility. In an age when few professional contributions can be read and understood by non-specialists, much less by interested non-economists, Coase’s work is readily comprehensible by the educated layperson. Now is the time to rehearse the insights that made Coase’s name a byword within the economics profession. His death makes this review emotionally as well as intellectually fitting.

Why Do Businesses Exist?

At 26 years of age, Ronald Coase was a left-leaning economics student. He pondered the following contradictory set of facts: On the one hand, socialists ever since Saint-Simon had advocated running a nation’s economy “like one big factory.” On the other hand, orthodox economists declared this to be impossible. Yet some highly successful corporations reached enormous size.

Who was right? It seemed to Coase that the answer depended on the answer to a more fundamental question – why do businesses exist? Be it a one-person shop or a huge multinational corporation, a business arises voluntarily. What conditions give birth to a business?

Coase found the answer in the concept of cost. (In his 1937 article, “The Nature of the Firm,” Coase used the term “marketing costs,” but the economics profession refined the term to “transactions costs”.) A business arises whenever it is less costly for people to organize into a hierarchical, centralized structure to produce and distribute output than it is to produce the same output and exchange it individually. And the business itself performs some activities within the firm while outsourcing others outside the firm. Again, cost determines the locus of these activities; any activity more cheaply bought than performed inside the firm is outsourced, while activities more cheaply done inside the firm are kept internal.

Like most brilliant, revolutionary insights, this seems almost childishly simple when explained clearly. But it was the first lucid justification for the existence of business firms that relied on the same economic logic that business firms themselves (and consumers) used in daily life. Previously, economists had been in the ridiculous position of assuming that businesses used economic logic but arose through some non-economic process such as habit or tradition or government direction.

Today, we have a regulatory process that flies in the face of Coase’s model. It implicitly assumes that markets are incapable of correctly organizing, assigning and performing basic business functions, ranging from safety to hiring to providing employee benefits. To make matters worse, the underlying assumption is that government regulatory behavior is either costless or less costly than the correlative function performed by private markets. As Coase taught us over 75 years ago, this flies in the face of the inherent “nature of the firm.”

The “Coase Theorem”

In mid-career, while working amongst a group of free-market economists at the University of Virginia, Ronald Coase made his most famous discovery. It assured him immortality among economists. Just about the best way to make a name for yourself is to give your name to a theory, the way John Maynard Keynes or Karl Marx did. But in Coase’s case, the famous “Coase Theorem” was actually devised by somebody else, using Coase’s logic – and Coase himself repudiated the use to which his work was put!

To appreciate what Coase did – and didn’t do – we must grasp the prior state of economic theory on the subject of “externalities.” Tort case law contained examples of railroad trains whose operation created fires by throwing off sparks into combustible areas like farm land. The law treated these cases by either penalizing the railroad or ignoring the damage. A famous economist named A. C. Pigou declared this to be an example of an “externality” – a cost created by business production that is not borne by the business itself because the business’s owners and/or managers do not perceive the damage created by the sparks to be an actual cost of production.

Rather than simply penalizing the railroad, Pigou observed, the economically appropriate action is to levy a per-unit tax against the railroad equal to the cost incurred by the victims of the sparks. This would cause the railroad to reduce its output by exactly the same amount as if it had perceived its sparks to be a legitimate cost of production in the first place. In effect, the railroad “pays” the costs of its actions in the form of reduced output (and reduced use of the resources necessary to provide railroad transport services), rather than paying them in the form of a fine. Why is the former outcome better than the latter? Because the purpose is not to hurt the railroad as retaliation for its hurting the farmer, the way one child hurts another in revenge for being hurt. A railroad is a business – in effect, it is a piece of paper expressing certain contractual relationships. It cannot feel hurt the way a human being can, so the fine may make the farmer feel better (if he or she received the fine as proceeds of a tort suit) but does not compensate for the waste of resources caused by having the railroad produce too much output. (“Too much” because resources will have to be devoted to repairing the damage caused by the sparks, and consumers value the resources used to do this more than the farmer values the loss.) In contrast, when the costs are factored into the railroad’s production decision, everybody values the resulting output of railroad services and other things as exactly worth their cost.

Of course, the catch is that somebody has to (1) realize the existence of the externality; and (2) calculate exactly how much tax to levy on the railroad to neutralize (or internalize) the externality; and then (3) do it. In the manner of a philosopher king, Pigou declared that this task should be assigned to a government regulatory bureaucracy. And for the next half-century (Pigou was writing in the early 1900s), mainstream economists salivated at the prospect of regulatory agencies passing rules to internalize all the pesky externalities that liberals and bureaucrats could dream up.

In 1960, Ronald Coase came along and gave the world a completely new slant on this age-old problem. Consider the following type of situation: you are flying from New York to Los Angeles on a low-price airline. You have settled somewhat uncomfortably into your seat, survived the takeoff and are just beginning to contemplate the six-hour flight when the passenger in front of you presses a button at his side and reclines his seatback – thereby preempting what little leg room you previously had. Now what?

This is not actually the example Coase used – it was used by contemporary economist Peter Boettke to illustrate Coase’s ideas – but it is especially good for our purposes. Using the same logic Coase applied to his examples, we reason thusly: It would be completely arbitrary to assign either of us a property right to the space preempted by the seatback. Why? Because the problem is not to stop bad people from doing bad things. Instead, we are faced with a situation in which ordinary people want to do good things that are in some sense contradictory or offsetting in their effects. On the airplane, my wish to stretch out is no more or less morally compelling than his to recline. The problem is that  we can’t do both to the desired extent at the same time without getting in each other’s way; e.g., offsetting each other’s efforts.

Indeed, this is true of most so-called externalities, including the railroad/farmer case. Case law usually treated the railroad as a nefarious miscreant imposing its will on the innocent, helpless farmer. But the railroad’s wish to provide transport services is just as reasonable as the farmer’s to grow and harvest crops. It is not unthinkable to enjoin the railroad against creating sparks – but neither should we overlook the possibility of requiring the farmer to protect against sparks or perhaps even not locate a farm within the threatened area. Indeed, what we really want in all cases is to discover the least-cost solution to the externality. That might involve precautions taken by the railroad, or by the farmer, or emigration by the farmer, or payment by the railroad to the farmer as compensation for the spark damage, or payment by the farmer to the railroad as compensation for spark avoidance.

 

In general, it is crazy to expect an uninvolved third party – particularly a government regulator – to divine the least-cost solution and implement it. The logical people to do that are the involved parties themselves, who know the most about their own costs and preferences and are on the scene. These are also the people who have the incentive to find a mutually beneficial solution to the problem. In our airline example, I might offer the man in front of me a small payment for not reclining. Or he might pay me for the privilege of reclining. But either way, we will bargain our way to a solution that leaves us both better off, if there is one. One of us would object to any proposed solution that did not leave him better off.

Of course, it would be useful for bargaining purposes to have an assignment of property rights; that is, a specification that I have the right to my space or that the man in front of me has the right to recline. That way, the direction of compensatory payments would be clear – money would flow to the right-holder from the right-seeker.

What if bargaining does not produce an efficient outcome, one that both parties can agree on? That means that the right-holder values his right at more than the right-seeker is willing to pay. But in that case, no government tax would produce an efficient outcome either.

On the airline, suppose that I value the leg room preempted by the reclining seat at $10. Suppose, further, that airline policy gives him the right to recline. If I offer him $6 not to recline, he will accept my offer if he values reclining at any amount less than $6 – say, $5. Notice that we are now both better off than under the status quo ante bargain. I get leg room I valued at $10 – or course, I had to pay $6 for it, but that is better than not having it at all, just as having the airline’s cocktail is better than being thirsty even though I had to pay $5 for it. He loses his right to recline, but he gets $6 instead – and reclining was only worth $5 to him. He is better off, just as he would be if he accepted an airline’s offer of $500 to surrender his seat and take a later flight, as sometimes happens.

We cannot even begin to estimate how many times people solve everyday problems like this through individual bargains. The world would be vastly better off if we were trained from birth in the virtues of a voluntary society where bargaining is a way to solve everyday disputes and make everybody better off. That training would stress the virtues of money as the lubricant that facilitates this sort of bargain because it is readily exchangeable for other things and because it is the common denominator of value. Instead, most of us are burdened by an instinctive tribal suspicion that money is evil and bargaining is used only to seek personal advantage at the expense of others. Experienced businesspeople know otherwise, but throughout the world the Zeitgeist is working against Coase’s logic. More and more, government and statutory law are held up as the only fair mechanism for resolving disputes.

University of Chicago economist George Stigler used Coase’s logic to devise the so-called Coase theorem, which says that when the transactions costs of bargaining are zero, the ultimate price and output results will be the same regardless of the initial assignment of property rights. This is true because both parties will have the incentive to bargain their way to an efficient improvement, if one exists. The assignment of property rights will affect the wealth of the bargainers, because it will determine the direction of the money flow, but economists are concerned with welfare (determined by prices and quantities), not wealth. No government regulatory body can improve on the free-market solution.

Coase disagreed with the theorem named after him – not because he disputed its logic, but because he foresaw the results. Economists would use it to look for circumstances when transactions costs were low or non-existent. Instead, Coase wanted to investigate real-world institutions such as government to compare its transactions costs to those of the market. He knew that real-world transactions costs were seldom zero but that government solutions almost never worked out as neatly in practice as they did on the blackboard. In fact, he invented the phrase “blackboard economics” to refer to solutions that could never work in practice, only on a theoretical blackboard, because real-world governments never had either the information or the incentive necessary to apply the solution.

Why China Became Capitalist

Ronald Coase devoted his last years to learning how and why China evolved from the world’s last major Communist dictatorship to the world’s emerging economic superpower. In Why China Became Capitalist, he and his research partner Ning Wang delivered an account that contravened the popular explanation for China’s rise. China’s ruling central-government oligarchy has received credit for the country’s emergence as the growth leader among developing nations. Since the Communist Party retained political control throughout the growth spurt, it must have been responsible for it – so the usual explanation runs. Coase and Wang showed that government’s presence as the agency in charge of political life does not automatically entitle it to credit for economic growth.

The death of Mao Zedong in 1976 rescued China from decades of terror, famine and dictatorship. Mao’s designated successor, Hua Guofeng, was an economist who outlined a program of state-run investment in heavy industry called the “Leap Outward.” This resembled the various Five-Year Plans of Soviet ruler Joseph Stalin in general approach and in overall lack of results. Hua’s successors, Deng Xiaoping and Chen Yun, abandoned the Leap Outward in favor of an emphasis on agriculture and light industry. Although Deng was the political figurehead who garnered the lion’s share of the publicity, Chen was the guiding spirit behind this second centralized plan designed to spur Chinese economic growth. It placed less emphasis on production of capital goods and more on consumer goods. Chen allowed state-controlled agricultural prices to rise in an effort to stimulate production on China’s collective farms, which had failed disastrously under Mao, resulting in approximately 40 million deaths from famine. He also allowed state-run enterprises a measure of autonomy and private profit, heretofore unthinkable under Communism.

Although these central-government measures were the ostensible spur to China’s remarkable growth run, Coase and Wang assign actual responsibility to the resurgence of China’s private economy. Private farms had always existed as part of the nation’s 30,000 villages and towns, much as neighboring Russians continued to nurture their tiny private plots of land alongside the Soviet collective farms. And, just as was the case in Russia, the smaller private farms began to outdo the larger collectives in productivity and output. Mao fanatically insisted on agricultural collectivization, but his death freed private farmers to resume their former lives.  By late 1980, the Beijing government was forced to officially acknowledge the private farms. In 1982, China formally abandoned its costly experiment with collective agriculture and de-collectivized its farms. Official grain prices were allowed to rise and grain imports were permitted.

Agriculture wasn’t the only industry that flourished at the local level. Small businesses in rural China labored under official handicaps; their access to raw materials was not protected and they had no officially sanctioned distribution channels for their output. But they bought inputs on the black market at high prices and groomed their own sales representatives to scour the nation drumming up business for their goods. These local Davids outperformed the state-run Goliaths; they were the real vanguard of Chinese economic growth.

Growth was slower in China’s major cities. Mao had sent some 20 million youths to the countryside to escape unemployment in the cities. After his death, many of these youths returned to the cities – only to find themselves out of work again. They demonstrated and formed opposition political movements, sometimes paralyzing daily life with their protests. This forced Beijing to permit self-employment for the first time – another Communist sacred cow sacrificed to political expediency. This, in turn, created an urban class of Chinese entrepreneurs. This led to yet another government reaction in the form of Special Economic Zones, somewhat reminiscent of the U.S. “enterprise zones” of the 1980s. Economic freedom and lower taxes were allowed to exist in a controlled environment; Chinese officials hoped to encourage controlled doses of capitalist prosperity in order to save socialism.

Gradually, the limited reforms of the Special Economic Zones became more general. Increased freedom of market prices was introduced in 1992, taxes were lowered in 1994 and privatization of failing state-run enterprises began in the mid-1990s. For the first time, China began to replace local and regional markets with a single national market for many goods.

Coase and Wang identify perhaps the most important but least-known capitalist element to arise in China as the improved pursuit of knowledge. They accurately attribute the recognition of knowledge’s role in economics to Nobel Laureate F.A. Hayek and note the increasing popularity of books and articles by Hayek, his mentor Ludwig von Mises and classical forebears such as Adam Smith. The economics profession has pigeonholed the subject of knowledge under the heading of “technical coefficients of production,” but the authors know that this is only the beginning of the knowledge needed to make a free-market economy work. The knowledge of market institutions and the dispersed, specialized “knowledge of particular time and place” that can only be collated and shared by free markets are even more important than technical knowledge about how to produce goods and services.

The upshot of China’s private resurgence has been to make the country a “laboratory for capitalist experimentation,” according to Coase and Wang. That laboratory has brewed a recipe for unparalleled economic growth since the 1990s, leading to China’s admittance into the World Trade Organization in 2001. The final piece of the puzzle, the authors predict, is a true free market for ideas – the one thing that Western economies have that China lacks. When this falls into place, China will become the America of the 21st century.

Thus did Ronald Coase add a landmark study in economic history to his select resume of classic works.

Quality vs. Quantity

Never in the history of economics has one economist achieved so much productivity with so little scholarly output. Ronald Coase economized on the scarce resources of time and human effort (ours) by devoting the longest career of any great economist to specializing in quality, not quantity, of work.

DRI-293 for week of 3-3-13: The Sequester: A Barack H. Obama Production

An Access Advertising EconBrief:

The Sequester: A Barack H. Obama Production

The appearance of First Lady Michelle Obama as presenter of the climactic Best Picture Academy Award at the recent Oscar ceremony is the latest sign of the symbiosis between American politics and Hollywood. The convergence between the political and entertainment industries is now so close that we can use the same economic model to analyze them.

Since both industries are popular and objects of public scrutiny, this model will have great practical value. Its first application will be to analyze the sequester, the current political-theater production now enjoying its first run on popular media throughout the nation.

The Model

The late Nobel-Prize-winning economist James Buchanan campaigned tirelessly against what he called the “romantic view” of government as the promoter of the “public interest.” Government is composed of particular individuals. In order to be operational, the concept of the “public interest” must be comprehensible to those people. If the activities of government were limited only to those whose net benefits were positive for everybody, it would be a miniscule fraction of its present size. Clearly, the actual purposes of government are redistributive. But what unique redistributive plan could possibly command unanimous support from the bureaucratic minions of government? The only conceivable answer is that bureaucrats serve their own interests, presumably having convinced themselves that their interest and the public interest coincide.

Government bureaucrats thus share a common goal with private business owners. But whereas private businesses produce goods and services in markets under the discipline of market competition, governments provide only executive, legislative and judicial services while contracting out for the production of and needed goods and services. Far from submitting to the discipline of competition, governments claim monopoly privileges for themselves and dispense them to others – often in exchange for political support.

From inception until the gradual disintegration of the studio system of moviemaking, Hollywood operated under the marketplace model of competition. When adverse antitrust decisions in the 1940s killed the long-term viability of the giant studios, movies changed their way of living. This drift away from competitive capitalism accelerated over the last two decades. Today, the approach of government and Hollywood to production is remarkably similar.

Private businesses produce goods and services in order to satisfy the demand of consumers. They satisfy consumer demand in order to earn profits and maximize the profit of their owners. Thus, both sides of the market strive to maximize their real income or utility through the consumption of goods and services. Consumers act directly when purchasing for their own consumption or saving for their future consumption. Producers act indirectly when producing for the consumption of others or directly when producing for themselves. Input suppliers act indirectly by supplying labor and raw materials to producers to facilitate production and consumption for others.

Governments cannot act as private businesses do because their bureaucrats are not spending their own money and taxpayers have no effective leverage over them. Bureaucrats serve their own interests – which are those of the politicians who control their fate. Politicians, in turn, most want to retain their hold on office. For the most part, this is accomplished by redistributing money in favor of those who vote for them. Since government has little or no power to increase the supply of goods and services but considerable power to reduce it, redistribution is accomplished predominantly by harming some people while purporting to help others.

We know that private production is beneficial because consumers voluntarily choose from among many competing products in a free marketplace in which producers can enter and leave at will. The existence of prices allows everybody to incrementally assess the value of every unit of input and output to insure its net benefit before purchase. Profit directs the flow of resources to areas of greatest value to consumers.

None of these safeguards applies to political production. In government, the principle of coercion replaces voluntary choice. No profits exist to tell bureaucrats whether they have succeeded or erred. No prices direct the incremental flow of resources and no competition is allowed to provide an alternative to government provision of goods and services. Sure, voting does take place. But the notion that a one-time choice between a restricted field of two candidates can somehow take the place of millions of everyday choices made under vastly better marketplace circumstances is quaint, if not utterly ridiculous.

How Hollywood Has Come to Resemble Politics

More and more, Hollywood production has come to resemble political production. This evolution has accelerated during the last two decades.

Under the old studio system, motion-picture production often left the confines of Hollywood in favor of distant locations. This was sometimes motivated by concern for production values, as when director John Ford sought the scenic vistas of Monument Valley, Utah for his revival of the Western genre in the 1939 film Stagecoach. Increasingly, however, economics lay behind the decision of producers to abandon Hollywood in favor of locations in the eastern U.S., Canada, Mexico, Spain or elsewhere in Europe. Hollywood production was hamstrung by inefficient work rules established by Hollywood craft unions under the sway of organized crime. It became far cheaper to incur heavy travel costs to foreign locations than to bear the costs of a Hollywood shoot.

That was back in the day when Hollywood still operated under the rules of economics that govern private markets. Today, every state of the Union has a state-level “department of economic development.” These Orwellian entities are distinguished by their lack of adherence to economic principles. In particular, they offer subsidies to private businesses for locating and operating within the state. In the case of motion pictures, this takes the form of subsidies to production companies that shoot movies in-state. The rationale for this activity is almost always a purported “multiplier benefit” to the location’s “economy.”

A subsidy is the opposite number of a tax. Both drive a wedge between the price paid by the buyer and that received by the seller; both are inefficient actions with adverse effects on production and consumption. Whereas a tax causes too little of the taxed good to be produced and consumed, a subsidy causes too much production and consumption of the good affected and too little production and consumption of other things. State agencies justify their actions by ignoring their bad results in favor of the supposed good effects.

The most highly touted benefit of movie-location subsidies is “job creation.” Even under the studio system, it was standard operating procedure for casting directors to scour the rolls of local actors to play subordinate parts, rather than pay travel expenses and higher salaries of Hollywood actors. The principal cast, whose work comprised the guts of the movie, was chosen on the basis of star power and acting ability. This was basic economics at work. Today, however, the pretense that subsidies are necessary to insure work for locals and keep local industry alive is another way in which Hollywood has abandoned economics for politics. Movie subsidies are directly analogous to protective tariffs (taxes) levied on foreign goods to make their prices higher than local prices, thus protecting the jobs of local workers.

There is no economic value in creating or protecting jobs because the end-in-view in all economic activity is consumption, not production. The idea is to provide the best combination of output quantity and quality. The implication behind job creation – rarely stated outright but unmistakable – is that our goal should be to maximize the quantity of human labor employed in producing output, rather than to produce the most and best output. This suggests that the profession of economics should hold up ancient Egypt as its model state. The production of pyramids using slave labor may be the best means ever devised for maximizing the number of human beings doing work and eliminating unemployment. (The slave-labor camps in the old Soviet Union’s Gulag Archipelago are a legitimate contender for the title, but lose out on the grounds that they produced comparatively little tangible output and services.)

Since the general idea is to make people as happy as possible, though, we can rule out “job creation” as our lodestar. The reason it is such a popular political goal despite its economic drawbacks is that it concentrates benefits heavily on a group of easily identifiable people who can readily recognize and gauge their gains. The beneficiaries of a job-creation policy are a good bet to vote for their benefactor.

Another prime example of Hollywood’s shift from economic to political priorities is the re-ordering of the bottom line. The mainstream media still behaves as though the success or failure of a movie depends on its box-office receipts. This was certainly true throughout the 20th century, during the birth and development of the motion picture. But it is no longer true today.

Most movies today are conceived or at least approved by the “talent” – stars, writers, directors and their agents. Studios are coordinating and marketing vehicles. The astronomical fees commanded by the talent, together with high labor and insurance costs, make it prohibitively expensive to make most movies. The only way turn a profit is by marketing ancillary products to young customers. Most movies lose money at the box office and are subsidized by ancillary revenues and (as the studio level) the occasional box-office blockbuster.

The shift in priorities away from the box office has allowed the talent to cater to their own tastes in choosing the subject matter of movies. Under the studio system, the preferences of the audience were worshipped by movie-studio moguls like Louis B. Mayer, Irving Thalberg, Harry Cohn and Darryl Zanuck. Many of the moguls were immigrants and Jews who had strong opinions and might have loved to indulge their own tastes. Instead, they ruthlessly pruned the esoteric and controversial output of their directors, writers and stars because their instincts sensed that public tastes would not embrace it. Now Hollywood’s implicit motto is “the public taste be damned” – an attitude it would condemn unhesitatingly were it struck by a private industry producing hula hoops, automobiles or soap. This allows the talent to freely indulge their political preferences on screen.

Hollywood’s bias has long been to the Left. The Obama administration is now busily engaged in centralizing as much production as possible under the aegis of government – executive, legislative, judicial and regulatory. The case of Solyndra is a representative example of the results. Large subsidies were given for the production of an alternative energy facility. Market demand was unfavorably disposed toward the company’s output and it lost money hand over fist. But ancillary considerations – in this case, the ostensible necessity for the gestation of alternative energy production – outweighed the losses in the disposition of funds.

Losses, subsidies and the substitution of personal priorities for those of consumes has long characterized political production. But now it describes Hollywood, too.

How Politics Has Come to Resemble Hollywood

In the early 1950s, veteran actor and movie star Robert Montgomery was asked to tutor President Dwight D. Eisenhower on the fundamentals of spoken communication to improve Eisenhower’s performance in televised speeches and news conferences. Much was made of this intrusion of Hollywood into the pristine, public-spirited world of politics. The election of Ronald Reagan as Governor of California and U.S. President led to his subsequent anointing as the “Great Communicator” – a title that was given a pejorative cast by his critics on the Left. While these episodes may have painted the Oval Office with a show-business veneer, they hardly tell a story of Faustian corruption.

Today, however, candidates are chosen on the basis of qualities associated with movie stars rather than statesmen. Would a candidate as homely as Lyndon Johnson or with the profile of William Howard Taft even bother to register for the Presidential primaries? Journalists have expressed a public longing to sleep with Bill Clinton and Barack Obama, even though political scientists have never ranked amatory skill among the vital attributes of a Chief Executive. The candidacy of Mitt Romney was widely felt to be fatally handicapped by his biography, as if a Presidency were a movie that needed suitable first and second acts to set the stage for a dramatic finish.

Movies are an emotional medium rather than an intellectual one. Their narrative form is highly stylized, based on that of the theater. Movie scripts can be divided into first, second and third acts. There is a (preferably heroic) protagonist, who wages a conflict with one or more villains during the course of the movie. The protagonist undergoes a transformative experience and emerges better for it. There is a climactic resolution of the conflict.

Today, politicians structure campaigns and issues in this manner. They cast themselves as the hero. They demonize their political opponents as villains. And, most importantly, they appeal to the emotions of voters rather than to their intellect.

The timing of announcements, and sometimes even the substance of policies, is determined by “optics” – the snap judgments and emotive reactions of the public. The weight of issues is measured by their standing in opinion polls rather than by their impact on the real incomes of citizens. Like motion pictures, politics has become a purely emotional business in which objective truth is completely overshadowed by subjective perception.

The Sequester: A Barack H. Obama Production

Now we are engaged in a great civil debate on the issue government spending. It will ultimately determine whether our nation – or any nation so constituted – can long endure. The opening volley in that debate has been fired by President Obama himself. But it has not been launched in the rhetorical tradition of intellectual inquiry and contention. Instead, it has been presented as a production of political theater – a Barack H. Obama production. Its title is: “The Sequester.”

In 2011, the Obama administration and Congressional Republicans fought a symbolic struggle over the raising of the debt limit. In order to orchestrate a victory over Republicans, the President crafted the sequester. The word “sequester” means “to set apart, segregate, or hand over (as to a trustee).” That refers to funds in the budget that were removed from consideration for spending purposes. In return for agreement to raise the debt limit, the President met Republicans halfway by agreeing to spending reductions in the form of sequestration.

Now, in 2013, when the time to follow up on his promise has come, President Obama has rewritten the script. He has recast himself as the hero and Republicans as villains in a melodrama in which spending reductions threaten hardship and economic setback. The original terms of the sequester called for $1.2 trillion in spending reductions spread over 10 years, averaging out to around $120 billion per year in reductions.

The actual reduction for 2013 would be about $85 billion. But there is more to the story. First, the cuts come only from so-called discretionary spending; entitlement programs like Social Security and Medicaid are unaffected. Second, the $85 billion figure reflects a reduction in budgetary authority – the statutory authorization to spend. Actual reduction in government outlays is projected to be only half the $85 billion total, or about $42 billion. The difference is accounted for by “baseline budgeting,” the notorious government budgetary practice that automatically increases expenditures every year. When the budget is ruled by the implicit logic that government spending is always good and a growing country will always need more of it from year to year, it is easy to grasp why the federal government is swimming in a sea of debt.

The biggest chunk of sequestration (about half of the authorized total) is slated to come from military expenditures. The remainder is sprinkled more or less equally throughout the federal discretionary budget, with the proviso that it should be distributed to cause the most pain to the populace. Does that sound like a pejorative characterization? No, The Wall Street Journal cited a memo to precisely that effect. Perhaps the most telling index of the melodramatic nature of this Barack H. Obama production came from a White House memo announcing that free tours of the White House would be cancelled until further notice due to “staffing reductions” caused by the sequester. As various bloggers hastened to point out, the tours are conducted by volunteers.

The President’s exercise in political theater contained many other dramatic high points. A White House fact (!) sheet stated that federal programs like Meals On Wheels would serve 4 million fewer meals thanks to the sequester. The document also claimed that 70,000 youngsters “would be kicked off Head Start,” the subsidy program for pre-school education, thanks to the sequester – a claim backed up by Health and Human Service Secretary Kathleen Sebelius. White House Press Secretary Jay Carney expressed grave concern for federal-government janitors who would receive less overtime pay because of the sequester. Department of Education Secretary Arne Duncan made headlines by declaring that there are “literally now teachers who are getting pink slips,” a whopper so outrageous that he was forced to retract it within 24 hours. Not to be upstaged by his supporting cast, the President himself gravely warned that federal prosecutors “will have to let criminals go” if the sequester is allowed to proceed.

The public is accustomed to seeing movies tell lies in the service of dramatic effect. That is exactly what this Barack H. Obama production does. Like many popular movies, it has borrowed its storyline from other successes. For over three decades, state government legislatures have faced laws – such as Missouri’s Hancock Amendment – limiting state-government spending. The standard legislative tactic of opponents is to concoct a fantasy wish-list of worst-case spending reductions designed to terrify voters into repealing the laws. In fact, the laws say nothing about specific spending cuts. They allow the legislators themselves the flexibility to choose which spending to cut. The legislators are supposed to cut the most wasteful, redundant spending and retain only vital programs – assuming there are any. Yet in practice, the legislators do just the opposite – they pick the most painful cuts in order to blackmail voters into spending ad infinitum.

That tactic, straight from the playbook of radical activist Saul Alinsky, is the plotline of “The Sequester.” It makes no sense. When air-traffic controllers went on strike in 1981, President Ronald Reagan protected consumers, who were otherwise helpless against the threat posed by a government monopoly. He fired the striking controllers and hired replacements. Are we confronted by angry restaurant owners who threaten to close up unless we spend more money dining out? Of course not; the restaurant industry is competitive. Strikers would simply lose business to competitors who would step up to serve consumers. But government monopoly employees can successfully hold taxpayers hostage unless the Executive branch fulfills its duty to protect the public. Instead, the Obama administration is siding with the blackmailers.

The Administration’s economic rationale for its actions is transparently absurd. Unofficial Administration economic advisor Paul Krugman hints darkly of 700,000 lost jobs and the CBO forecasts a loss of one-half point’s worth of economic growth – all due to a net reduction in discretionary spending of $42 billion. Yet the Administration absolutely demanded that the Bush tax cuts end on schedule, producing a much larger effect on “aggregate demand” by Keynesian economic lights. Krugman has consistently maintained that the 2009 stimulus of nearly $800 billion was not nearly large enough to produce marked effects, so how can he now bemoan this piddling spending reduction?

Movie plots are not supposed to make sense. They are structured for emotional impact only. Producers, directors and screenwriters are granted dramatic license to lie in order to manipulate our emotions. Their actors and actresses are expected to speak lines from a script in order to enact the drama.

This is what politics has become. It is political theater, dedicated to the proposition that government of itself, by itself and for itself, shall not perish from the Earth.

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.

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.