Cite As: David Teece, Telecommunications in Transition: Unbundling,
Reintegration, and Competition, 1 MICH.TELECOMM.TECH.L.REV.
47 (1995),
available at <http://www.mttlr.org/volone/teece.html>.
Comments about this article should be sent to mttlr@umich.edu.
{2} This paper outlines these technological changes and explores their implications for competition policy, industry structure, and business organization. Part I introduces competition as an organizational model and discusses the existing structure of the telecommunications industry in the United States. Part II describes recent technological advances that change the conditions underlying the current regulatory structure of the telecommunications industry and challenges the effectiveness and validity of the current regulatory scheme. Part III discusses how innovation impacts what has been considered the natural monopoly of local exchange. Part IV advances five principles that should guide policy modification. Part V explores how eliminating the line-of-business restrictions created by the Modification of the Final Judgment[1] between the government and American Telephone and Telegraph Co. will accelerate competition and stimulate the development of the Information Superhighway. Ameritech's Customer First Plan is presented as a viable means to enhance competition, avoid redundant investment, and increase service innovations and technological advances. Part VI discusses the impact of removing interLATA restrictions.
{3} The organizational model most capable of delivering advanced services universally and at low cost is one that relies on competition and cooperation.[2] Competition will ensure that incentives exist to provide new services at low cost. Cooperation, governed by antitrust laws, will ensure that the various networks based on copper wires, coaxial cables, fiber optic cables, and airwaves are knit together into a "network of networks." In combination, competition and cooperation will ensure that vestigial elements of any remaining essential facilities in the local exchange business are accessible in a non-discriminatory fashion and that people can communicate anytime, anywhere, to anyone.
{4} The United States has already moved quite some distance toward implementing this model. Since the late 1970s, the government has embraced competition as a matter of public policy for the telecommunications industry.[3] Moreover, "the genie of competition has been set loose from the bottle and is unlikely ever to be squeezed back in."[4] Nor should it. In the United States, if not everywhere, competition is far and away the most promising route for efficiently bringing forward the advanced telecommunications services needed to enhance global competitiveness in the decades ahead. However, the existing structure prevents realization of the benefits of integration. The predivestiture Bell companies, whatever their faults, did bring forward network innovation that kept the United States second to none in the efficient provision of telecommunications services for decades. The benefits of the former integrated system can be available today. Many of the problems of the existing system, such as, declining investment, slow rates of new product innovation, and limited network innovation, can be addressed if the embargo under which the Regional Bell Operating Companies (RBOCs)[5] are operating is lifted. When coupled with unbundling of the local exchange, removal of the interLATA restriction[6] will create a framework that allows market forces to determine whether services are offered by an integrated or a nonintegrated entity and how different services are priced. This will leave federal and state regulators more focused on monitoring safeguards and championing innovation rather than simply standing in innovation's way. Also, inefficient investments that have sprung up purely as artifacts of regulation will fade away, as they should. Scarce investment dollars can then be steered where they need to go: not into the unnecessary duplication of facilities, but rather, into the building of advanced digital intelligent networks.
{5} This model based on competition is by no means a pipe dream. It is the logical conclusion of the trend selected in the late 1970s and early 1980s to increasingly rely on competition rather than regulation to organize the market.[7] The model already finds full expression in New Zealand, where the Post and Telegraph Office (PTO) provider was privatized and the market was opened to competition.[8] The "Kiwi share" set a price cap on residential rates that moves with the rate of inflation and New Zealand's antitrust laws safeguard the interconnection rights of new entrants. Tremendous productivity improvements followed privatization and deregulation bringing New Zealand to a leadership position in the modernization of telecommunications infrastructure.
{7} Some key technologies that provide the enabling platform for these new telecommunications services are:
1. Bandwidth Explosion. The conversion to digital systems permits expansion in the number of channels carried by a transmission media. Optical fiber also permits a dramatic increase in the bandwidth that can be transported from point to point.[9]
2. Enhanced Microprocessor Power. New RISC-based microprocessors and digital signal processors permit faster, more efficient, and thus lower cost switching, data access, and digital compression.[10]
3. Reductions in Memory Cost. In recent years, the unit cost of memory has fallen dramatically,[11] thus allowing cost-effective storage and retrieval of large libraries of digital context.
4. Software Breakthroughs. Software developments are permitting quick, low-cost programming, access to large data bases, and inter-operability, which facilitate the integration of different types of media into multimedia products. Stored program control has dramatically improved the versatility of telecommunications products. Software breakthroughs are also permitting seamless, user-friendly operation.
5. Wireless Modulation. Techniques such as trunking[12] have been developed and are now being deployed that dramatically increase the capacity of the radio spectrum for voice and data.{8} Many of these technological developments change the conditions that form the basis of the current regulatory structure of telecommunications, making many of those regulations obsolete. Recognizing this, regulators and courts have begun to promote competition as the underlying principle for the organization of the telecommunications industry. Some regulatory changes include additional spectrum allocations for new services such as Personal Communication Servers (PCS)[13] and Enhanced SMR,[14] Federal Communication Commission (FCC) co-location and open network architecture (ONA)[15] policies, the lifting of information-services content restrictions on the RBOCs in July 1991,[16] and a July 1992 FCC ruling permitting local exchange carrier deployment of video dialtone.[17] Without these and other regulatory changes, the Information Superhighway would be just a dream.
{9} Indeed, it is well to recognize that the United States no longer holds a commanding lead in telecommunications. As one observer has noted:
The rate of network improvement in other countries is more rapid than in the United States and we are in serious danger of falling behind. For example, both Europe and Japan have plans to have a universal broadband service available by the year 2015, with fiber connections to every subscriber.[18]In addition, cable telephony is offered in Great Britain.[19] Combinations of U.S. telephone companies, including Nynex and Southwestern Bell, British cable companies, and U.S. cable companies, including Cox, Comcast, and Tele-Communications Inc. (TCI), have begun to offer cable telephone services in competition with British Telecom.[20] The success of these ventures has resulted in lower prices for local and long distance telephone services in Great Britain and an increase in the quality and variety of services offered.[21]
{10} In order to capture the benefits associated with these technological developments and facilitate their deployment in the private sector, regulatory policies and competition policy must rapidly evolve. Because of the speed of technological change, radical changes in regulatory policy and industry structure are needed. Technological innovation makes increasing competition in telecommunications both possible and inevitable. For example, the application of microwave technology to telecommunications made possible the entry of MCI, Sprint, and others into the long distance market. Today, dramatic breakthroughs in radio communications technologies are sharpening competition between wireless and wireline. Public policies are often slow to recognize the opportunities afforded by the new technologies, and regulatory and public policies often delay and distort competitive dynamics. In the United States, it is often the incumbent regulated firms that are most ensnared in policies that prevent new technologies from being rapidly embraced. This often impairs the ability of established firms to contribute to the investment needed to bring forth new services. The existing regulatory environment inhibits the most qualified providers of enhanced services to the obvious detriment of the nation.
{12} The traditional case for regulation assumed the existence of a natural monopoly: a situation where economies of scale persist over all relevant ranges of demand so that a single firm can serve the market at lower cost than two or more firms. Textbook treatments then typically use electric power, gas distribution, local telephone service, rail transport between small and medium city pairs, and the long distance pipeline transport of petroleum and gasoline as examples of natural monopolies.[25] It was often assumed, because detailed analysis was rarely reported or even performed, that regulation was necessary in such instances to protect consumers from the monopoly pricing behavior that was supposedly virtually inevitable when scale economies where achieved.
{13} Recently, however, scholarly work has begun to recognize that natural monopolies are not only extremely rare, but also do not necessarily have to be regulated.[26] The theory of contestable markets demonstrates that the presence of a large number of actively producing firms is not necessary to produce efficient outcomes.[27] Where costless, reversible entry, sometimes referred to as "hit and run" entry, is possible, firms that are characterized by economies of scale will still price at efficient levels. Put differently, the threat of potential competition can, under certain conditions, produce efficient outcomes even in markets where there is only one supplier or where a single supplier holds a substantial market share. However, the argument here is not that markets characterized by natural monopolies do not need to be regulated, although in some circumstances that is true. Rather, the proposition is advanced that the local exchange is not a natural monopoly anymore, if it ever was.
{14} Almost since the beginning of the telephone business, local telephone service has been provided by a copper pair of wires strung to each house. Because the major cost of providing local phone service was the cost of the wire and the wire was sufficient to carry the calls of each customer, it was significantly cheaper to have a single provider of local services. The cost savings from a single provider led to the widespread belief that a natural monopoly existed.
{15} For the past 20 years, technological change has transformed competitive conditions in the local exchange business. Technology is not only making the local exchange more susceptible to competition but also blurring the distinction between interexchange and intraexchange services.[28] The actual regulatory distinction between categories of service affects technical choice and network design and therefore may, itself, be an important factor in determining the direction of innovation and the nature of competition. For example, the introduction of fiber optics into the telephone networks has significantly reduced the cost of transport so that the cost of calls is very insensitive to distance.[29] As a result, depending on the amount of switching, the real resource cost of a 10 mile "local" call may not be very different from the cost of a 100 or 1,000 mile "long distance" call. However, because of regulation and imbedded subsidies, the prices charged for these calls remain different. In response to these price-cost discrepancies, many companies have been able to arbitrage the difference and route calls through the lowest priced jurisdiction even if it is not the least resource cost routing. This results from the implicit subsidies as well as the decrease in the cost of call transport.
{16} The implementation of fiber optic technology is not the only change that is affecting the economics of local communications. There are a variety of technological advances that have changed the nature and lowered the costs of local exchange. Which in turn threaten the natural monopoly and reduce the difference between long distance and local telephone calls.[30]
{17} New enabling technologies have lead and will continue to lead to alternative and enhanced provision of telephone service. The advance of technology has come in many different arenas and from many different enterprises in response to several different regulatory regimes. Especially pertinent to the discussion of "local" telephony are the impact of radio based technology, the introduction of fiber optics, the significant advances in microelectronics and computing power, and the continued decrease in the cost of computers and microelectronics.
{19} Radio has gone through a series of advances since it was first introduced. These advances are currently most evident in the explosion of cellular phone usage that has occurred over the last ten years. More cellular phone "lines" than new local exchange lines are activated each year.[31] Despite this growth and predictions that cellular might one day compete with landline service, cellular has not yet provided significant price competition with landline service. In some respects, this may be due to capacity limitations and the inability of providers to price discriminate between mobile and fixed services. The first problem, capacity constraints, is in the process of being rectified for the majority of the country with the conversion to digital signaling. Digital cellular transmission is expected to bring an immediate threefold increase capacity.[32] System capacity at that level will be sufficient to provide a competitive alternative to wireline service in all but the very largest areas of the country.
{20} Although cellular is currently providing only modest competition to landline service, several factors are likely to reduce cellular prices in the near future and make it more of a competitive alternative to landline service. Cellular is likely to face price competition from two sides in the near future. Nextel recently began operation of its digital, cellular SMR service in Los Angeles.[33] It is expected that Nextel will be able to provide cellular quality service with advanced technology.[34] The addition of a third high quality mobile service provider will expand capacity further and put downward pressure on prices. Other SMR operators also appear to have plans to introduce digital cellular technology to their networks.
{21} In addition, future wireless competition will put pressure on both cellular and landline service. PCS is expected to provide mobile communications and to add significantly to wireless capacity. Because the higher PCS frequencies have limited effective ranges, the handsets will be smaller than comparable cellular phones. However, these systems will require significantly more cells which may limit mobility. This limited mobility will cause them to charge lower prices than cellular systems and serve as competitors to portable and wireline phones in addition to many portable cellular phones.
{22} The additional capacity offered by the introduction of digital signaling and the increase in spectrum available for mobile communications will eliminate capacity constraints in most areas. At that time, service prices should be based on the cost of installing the infrastructure and maintaining the system. In many cases, these costs will be comparable to or lower than the costs faced by a traditional wireline company. Wireline costs diminish, the available spectrum widens, and cell sitting becomes less expensive as you move further away from dense urban areas. As a result, the wireless technologies are much more competitive with wireline service in rural areas.
{23} One additional future radio-based technology is the Iridium project proposed by Motorola. This project proposes a worldwide satellite network so that users can communicate anywhere throughout the world.[35] The signal will be directed to a satellite from the handset and then back to the other handset or local network. Although this is expected to be a relatively expensive service, it is another wireless technology that may someday turn "local" communications into global communications.
{25} Fiber has not only affected the cost structure of the interLATA carriers but also become an integral part of local exchange. Local telephone and cable companies are racing to introduce fiber into their networks. Just as Bell and the other telephone companies competed to wire networks, these two competitors are racing to be the first to have a high capacity two-way network and to reap the benefits of early adoption. There are many issues to be resolved about the introduction of fiber: whether it will be fiber to the home, fiber to the curb, or fiber to the neighborhood, for example. But it is clear that fiber and its carrying capacity have had, and will continue to have, a strong impact on the nature and cost structure of communications.
{26} The development of fiber optic technology has led to the first competitive alternative to Local Exchange Carriers: Competitive Access Providers (CAPs). CAPs have deployed fiber optic networks through dense downtown areas. In addition to the arguments that they are able to avoid the subsidies embedded in LEC access rates, the CAPs claim that they are satisfying a need for high capacity, high quality, high speed data transmission links. Without the transmission quality of fiber, CAPs would not be able to fill this need and therefore might not be able to exist and bring competitive pressure on LEC rates.
{27} Cheap transmission has a significant impact on the economics of information services. Many information services rely on accessing databases. With cheap transmission it becomes economical to have a single version of a database and allow users from a wide area to access the single database. In this way, the provider does not have to duplicate the facilities to run the database, updates to the database are simplified, and all users accessing the database receive consistent information.
{28} The preceding two sections show the complementary nature of the competitive effects of fiber and wireless technologies. Fiber is being introduced by CAPs and cable companies in dense urban areas to provide high capacity service. In these areas the costs of wiring per telephone is relatively low since the density is high. Also, in these areas spectrum is relatively scarce and expensive. Construction and operation of a high quality cellular-like system would be expensive because of the opportunity cost of the spectrum, the high price of the land rental for cell sites, and the need for a large number of cell sites. On the other hand, in suburban and rural areas it is more expensive to string wires, spectrum is less intensely used, and there are more options for cell sites. As can be seen, technology is challenging the existence of the natural monopoly in areas of both high and low population density.
{30} The decline in microelectronics prices will make it easier for cable companies to compete with LECs. For example, if the cable version of a telecommunications provision is a 500 channel interactive broadband network, the cost of the CPE to link into that network will be significantly cheaper and more sophisticated than it would have been only a few years ago. As a result, even if the cable and telco networks are significantly different, the competition on a variety of features ensures that the reductions in cost for cable telephony will make them more competitive with LECs.[38]
{31} The pace of electronics advance has blurred the distinction between transmission and switching as well as between central office equipment and CPE. For example, advancement in central office technology has allowed the offering of advanced voice messaging systems. Although these systems may offer more features than standard home answering machines, they nonetheless directly compete with home machines. PBXs[39] are another example of an advance outside the central office that has increased competition between central office services, Centrex,[40] and CPE. PBXs not only provide competition for central office services but also provide switching services, allowing users to reduce their use of loops and pay for fewer lines.
{32} The next section analyzes the effect of these technologies on the entry strategies of potential entrants into the local exchange.
{35} Time Warner's Orlando, Florida trial is another example of cable competing for local service. Set to be completed next year, the system as envisioned will be based on a fiber optic backbone, copper to the home architecture, digital compression technology and digital storage and switching systems.[47] The network will give the cable company the ability to offer, among other things, voice and data transmission services and PCS.[48] Jones InterCable recently announced a test of telephone service over its cable system.[49] With the help of MCI and Scientific Atlanta, Jones InterCable will be able to allow users to bypass the LEC and receive faxes while using the phone and to have access to interactive games.
{36} Comcast is also poised to begin telephone service.[50] The New York Times reported that Comcast had continuing talks with both AT&T and MCI, indicating their interest in telephone service.[51] Comcast also is one of the owners of Nextel, a specialized mobile radio company that recently received FCC approval to provide cellular-like service in a number of major cities.[52] Furthermore, Comcast offers cable and telephone service in Britain. In the United States, Brian Roberts, President of Comcast says, "Long term, the cable companies want to look like the phone companies with ubiquitous coverage. We've wired up nearly all the homes, but not the businesses. So that's why we're investing in Teleport."[53]
{37} Once these ventures and others begin offering services to consumers, a significant marketing advantage will emerge. A cable company can package its programming and phone service, offering the customer the convenience of one stop shopping, and possibly adjust the prices of the individual services to convince the customer to subscribe. Such bundling has proven highly successful in the U.K. As one example, Cable and Wireless, a British concern, is now signing-up close to 15,000 residential customers per month through the local cable companies.[54] There is no reason not to expect similar inroads here in the United States, especially with an interconnected network of networks.
{39} "Nonwireline" cellular carriers provide nearly ubiquitous service throughout the country. While their "loops" may not currently provide a complete, competitive alternative to LEC loops, they are positioned to do so easily. Cellular carriers have sophisticated switches and, in some cases, fully-functional networks and office support in place that will allow them to use spectrum for "fixed" loops and to provide competitive local service. Cellular carriers also possess a select list of customers with a high demand for telecommunications services. Cellular and other wireless carriers appear well-situated to provide future competition for the local loop, especially in relatively high-cost areas. Spectrum is used less intensively in rural areas than in major metropolitan areas. Therefore, providing competitive loops in these areas would not divert spectrum from a relatively more valuable use.
{40} In the future, the combination of leased wireline access and wireless access may give the cellular carriers a unique advantage in marketing to customers. If they succeed in their drive to receive PCS licenses, wireless carriers would provide customers with three options for "loops." Under one example, the cellular provider can position a cell site directly adjacent to a wireless PBX serving a large corporate complex. The cellular carrier could handle local mobile traffic and serve as the local carrier for all interLATA traffic originating and terminating at the PBX. Although the coverage for the cellular portion of the traffic would be more limited than for wireline traffic, the volume of traffic, combined with the absence of interconnect charges for the cellular carrier, would offset at least some of the gap.[56]
{41} With the imminent conversion to digital signaling for cellular, there are a number of cellular operators that will have significant excess capacity.[57] They can market this capacity for use as simple local service. In fact, products are being developed to allow cellular operators to sell service to wireline customers that is transparent to the user. Other implementations could include selling "loops" to serve as connections for alarms that need only infrequent access.
{43} Another group of potentially formidable competitors moving closer to actual entry with each passing month are the LECs from other regions. The RBOCs and GTE are all large, financially sound carriers with the requisite technical engineering, marketing, and billing capabilities to provide local exchange services. As already noted, US West, with Time Warner, intends to enter other regions and will soon begin providing local exchange service.[59] Entry by the other LECs is just as likely. Both Sprint and GTE have local exchange operations[60] and it would be logical for them to expand their service areas through a combination of resale and facilities construction. Most RBOCs have cellular operations in areas outside their local exchange territories. The market presence of these companies provides a natural springboard for the extension of the scope of their services into the local exchange. Such a strategy could be accomplished via their own facilities or by a pooling of talents and resources with the other potential entrants other than the Interexchange Carriers (IXCs) who are restricted by the MFJ.
{46} MCI, through its subsidiary Access Transmission Services, has filed for a permit to begin competitive access service provision in Indiana.[64] MCI also recently announced the planned test of cable telephony with Jones InterCable discussed above.[65] Sprint is already an active participant in local exchange telephony.[66] MCI and Sprint may have additional incentive to add end offices if prospective changes to switched and special access transport pricing make the IXCs more sensitive to the location of their switches. MCI and Sprint will then have incentives to provide their own links from high volume end offices to their POPs. This will create excess capacity and position them to take advantage of the unbundling and switch integration plan.
{47} All three companies have the ability to self-supply transport. Once the necessary construction and right-of-way expenses are incurred, the incremental cost to add traffic will be quite small.[67] Specifically, once the IXCs have successfully developed the transport segment of their network, they will be able to sign up additional subscribers at little added cost in an unbundled environment since they can rent loops from the LEC and transport traffic to their own switches. In addition, as a major manufacturer of switches, AT&T will be able to obtain switching at a lower cost than any of its competitors and could easily position switches for local service.[68]
{48} Because IXCs enjoy their highest margins in the small and mid-size business segment, they are likely to pursue these customers first for their provision of end-to-end service. AT&T, as well as other large IXCs, could compete by installing switches (or using excess capacity on its existing switches) to supply dial tone and usage services and routing the traffic to any of their many existing POPs. This could be economical even in an area with a small amount of traffic because the large IXCs could either share capacity on a nearby existing long distance switch or economically use a somewhat distant switch to provide local dialtone until traffic justifies a truly local switch. Adding switch capacity is relatively simple with modern modular switches such as the 5ESS. Furthermore, because the IXCs have fiber facilities in place with excess capacity, the cost of transport to take advantage of a distant "local" switch would be minimal.
{50} The strategic intent of CAPs appears to involve providing expanded services.[69] MFS Communications, Inc. has recently announced that it will offer local and long distance services in New York City.[70] To support this effort, it plans to install Ericsson switches in its network.[71] The service will be "available immediately in Manhattan and will be extended to the rest of the New York metropolitan area over the next few months."[72] MFS does not intend to stop with New York. According to its half page advertisement for this new service, "Service is available in New York now. National expansion is underway."[73]
{51} CAPs have invested in loops that give them access to a large number of customers with a relatively high demand for telephone service. CAPs may not be positioned to compete for customers throughout the local service areas, but they are well beyond the venture capital stage and now represent formidable competitors to the local exchange carriers. The largest CAP, Teleport, is owned by several large cable companies, including TCI, Comcast, and Cox and thus possesses the financial backing to ensure its ability to effectively compete.[74] This investment by the cable companies reveals their expectation that CAPs will provide telephony expertise and their belief that further synergies exist.
{52} Investment advisors and the CAPs themselves believe CAPs have a significant role in the future of telecommunications. In discussing the acquisition of Teleport by TCI and Cox, Goldman Sachs says that the alternative access market is "substantial" and represents a significant opportunity for cable companies.[75] TCI's CEO John Malone beleives there is a potential market of $40 billion annually for alternative access carriers; he expects the alternative acces market to generate revenues of at least $1 billion in three years and to potentially represent 25 percent of the total access marketplace.[76] Such optimistic numbers, while obviously not precise, are indicative of the potential for CAPs to become significant access providers.
{53} With switch integration, CAPs with switches can easily become the local phone service provider to those businesses their networks reach. In addition, the ability to rent loops in areas their networks do not reach will enable CAPs to provide service to businesses and residences with little incremental investment as long as those customers are served by end offices their networks do reach. CAPs can also expand their geographic coverage sequentially and determine the optimal path for their new fiber loops by leasing capacity in the short term while determining where to install plant expansions. Finally, the CAPs will be able to compete to serve multi-location businesses even when they do not have a physical presence near each of the satellite offices.
{54} CAPs also will be able to increase their target customer base significantly with unbundling. CAPs are already reaching new customers. With unbundling, CAPs may deploy fiber in other areas and reach even more potential customers. CAPs can use unbundling to determine demand for their services and perform true market research by purchasing pieces of LECs' networks before determining where to construct their own facilities. Further, CAPs will be able greatly to reduce the risk of new construction by establishing an active customer base prior to completing their facilities.
{55} Clearly, local exchange services are exposed to forms of competition not imaginable even a decade ago. Local exchange is certainly not the monolithic essential facility once described in industrial organization textbooks. New technology and regulatory changes have brought fundamental transformation. Competition increases daily. Full-scale competition in access, exchange, and interexchange services is both inevitable and desirable. Competition in telecommunications has not advanced yet to the point where it alone will suffice to guarantee all the public policy objectives traditionally embraced in the United States.[77] The rapid expansion of competition in the local exchange permits and requires regulatory changes and the development of new policies to further the transition to a fully competitive telecommunications environment.
{56} In order to capture the benefits of innovation, policy makers must make aggressive moves to modify the regulatord institutional approaches in place in the United States today. The following principles should guide this process.
{57} Replace Regulation with Competition. Enabling customers to choose among competitive service providers constitutes the most efficient form of "regulation." While competition will increase whether regulators want it to or not, good regulatory policy can ensure that competition proceeds more quickly and that all customers enjoy the benefits of competition. Also, good regulatory policy can promote the right kind of competition, that which responds to real market demands and reflects real economic efficiencies. Regulators should avoid policies that stimulate artificial competition wherein participants exploit regulatory distortions and arbitrage uneconomic pricing schemes.
{58} Promote Competitive Neutrality. Because technology is proceeding at breath-taking speeds and advanced telecommunications are becoming absolutely crucial to competitive success in more and more industries, it is vital to adopt policies that promote continued development of healthy competition in telecommunications while ensuring that social policy objectives, such as universal service, are maintained. Therefore, regulatory policies should be competitively neutral. Policies that treat competitors differently can bias customers' choices and distort entry and investment decisions. Policies should provide competitors with an opportunity to compete but should not attempt to guarantee their success. Policies should promote and protect competition, not protect competitors from competition.
{59} Facilitate Market Responsiveness. Public policies should attempt to be responsive to current and expected market conditions in both the industry being regulated and related industries. Prices, as signals of cost and value, play a critical role in market exchange. Regulators should therefore allow prices to be set by market forces whenever possible, or, alternatively, emulate market forces when they do set prices or pricing parameters. Similarly, regulators should allow, to the maximum extent possible, market forces to determine what variety of products and services will be offered. Regulators should recognize that market pressures have increased the rewards of good public policies (i.e., those which stimulate investment, increase usage, and promote economic development in the states) and the costs of policies that are not consonant with market conditions (e.g., uneconomic bypass, self-supply, and relocation of facilities).
{60} Synchronize Regulatory and Competition Policies. It is also important that rate regulation and competition policy are synchronized. As competition policies, whether by design or in effect, further open markets to competitive entry, regulatory policies should be reformed to ensure that they are consistent with actual and expected conditions in the marketplace. For competition policy to work well, pricing should be market driven with only limited, targeted exceptions. Competition policies should recognize when, and the degree to which, prices are not market driven. In the best situation, prices are regulated only when competition or customer discretion is inadequate to protect buyers from the exercise of market power.
{61} Remove Barriers to Entry and Competition. When technically feasible, and when balanced by appropriate changes in other regulations, regulations should be used to reduce or remove barriers to entry and competition. Probably the most important step in removing entry barriers in access and exchange services is unbundling the local network into its component parts. The most important step in removing entry barriers in interexchange competition is waiving or eliminating the MFJ line-of-business restriction that prevents the RBOCs from offering interLATA services.
1. Loops. Local loops on an unbundled basis at tariff rates established by state regulatory agencies. Ameritech will propose rates that are above long-run incremental costs but do not exceed fully distributed costs. Access to local loops would be at the main distribution frame or the digital cross-connect frame.
2. Switching. Interconnection to its local switching with loops provided by others. The switch integration of the Plan permits all providers to seamlessly connect to a "network of networks."
3. Signaling. Unbundling of SS7[80] call set-up capabilities and permitting competitors to access the SS7 signaling network without subscribing to Ameritech's transport or switching service.
4. White Pages Listings, 911 Service, Deaf-Relay Services. On an optional basis.
5. Cooperative Engineering. Cooperative engineering, operation, maintenance, and administrative practices on an optional basis.
6. Rights-of-Way. Where sufficient space permits, conduit and pole attachment space on a nondiscriminatory basis to authorized interconnectors.
7. Mutual Compensation. Mutual compensation arrangements at reciprocal rates for termination of traffic by state-certified alternate exchange providers.
8. Numbering Plans. Complete NXX codes[81] to other qualified providers.
9. Local Telephone Number Portability. Portability to the fullest extent permitted by current technology. The company is committed to supporting the development of more robust options through industry forums.
10. Usage Subscription. Use of Ameritech's loops and local dial tone provision while they carry all outbound traffic on their networks. In essence, this might be termed intraLATA presubscription. Thus, a new entrant can offer alternative service without requiring the customer to change telephone numbers.{63} The essence of the CFP is that it dramatically lowers entry barriers into the local exchange and quarantines residual sunk cost facilities, leaving the effectively contestable part of the local exchange under the control of market forces and the portion requiring substantial amounts of sunk capital (basically the local loop) subject to price cap regulation. The services of the sunk facility are provided to any industry participant, including Ameritech, on the same terms and conditions.
{64} The key to guaranteeing competitive outcomes in any context is the existence of conditions enabling entry. Even the threat of entry disciplines prices. This well-accepted proposition, historically rooted in the analysis of eminent economists as diverse as Sylos-Labini[82] and Schumpeter,[83] and recently renovated and extended by the insightful work of Baumol, Panzar and Willig,[84] means that if one lowers artificial entry barriers and new entrants need not incur significant sunk costs then all the benefits of competition are available regardless of the market share of the incumbent. This is, in essence, the market discipline the CFP will create. Of course, the state of the current technology may not instantaneously enable all elements of the local exchange to be contestable. However, providing the elements on a non-discriminatory basis and at price levels no higher than their opportunity cost will ensure "as if" contestability because the relevant businesses are effectively contestable. Professor Baumol is quite laudatory of Ameritech's efforts, noting that "Ameritech should be commended for addressing itself to the principal preconditions for ultimate removal of the interexchange restriction, that is, the elimination of entry barriers into exchange operations and the encouragement of exchange competition."[85] Indeed, the CFP is the embodiment of principles developed and vigorously advanced in other contexts by Professor Baumol over the past decade. He also notes that "unbundling, if it is carried out fully and effectively, can greatly facilitate the entry process."[86] Baumol further points out that unbundling will not transform loops into contestable markets.[87] But that answers the wrong question. The relevant inquiry is whether the services of the loop will be provided to all on a nondiscriminatory basis. Ameritech's recent tariff filings guarantee the answer to this question is affirmative.
{65} One can measure the degree of contestability of a market by the "share of the investment that is composed of capital that is sunk."[88] Setting aside the loop, the CFP enables a new entrant to enter practically any segment of the local exchange with truly a minimal investment. In this manner, Ameritech's unbundling and switch integration will facilitate and assist entry. Through the CFP, Ameritech offers its competitors the right to access its network at non-discriminatory rates.[89] The CFP essentially confers on Ameritech's competitors whatever economies of scale and scope Ameritech possesses. Few, if any, irreversible investments will need to be deployed by new entrants in order to compete because new entrants can simply rent from Ameritech. As Baily and Baumol note, "if an industry behaves as if it is contestable, most of the benefits of perfect competition can be attained without government intervention."[90]
{66} If implemented, Ameritech's unbundling plan will make the local exchange effectively contestable. A provider wanting to enter any segment could do so at relatively low cost. Entry barriers, in essence, would be eliminated. This flood of new entry will result in heightened competition, both in terms of price and service offerings. The latter is especially critical because service innovations and technological advances confer the greatest benefits upon telecommunications users. The competition to meet consumer needs and create new consumer demands will produce gains that dwarf the savings derived from intensified price competition.
It is probable that, over time, the Operating Companies will lose the ability to leverage their monopoly power into the competitive markets from which they must now be barred. This change could occur as a result of technological developments which eliminate the Operating Companies' local exchange monopoly or from changes in the structures of the competitive markets. In either event, the need for the restrictions . . . will disappear, and the decree should therefore contain a mechanism by which they may be removed.[94]The Court further noted "[t]he restrictions imposed upon the separated BOCs by virtue of section II(D) [the line of business restrictions] shall be removed upon a showing by the petitioning BOC that there is no substantial possibility that it could use its monopoly power to impede competition in the market it seeks to enter.[95]
{68} Unbundling along the lines proposed by Ameritech,
if faithfully implemented, would remove any residual concern that the RBOCs
could upset the terms of competition in the interLATA business. Absent
Congressional action, unbundling provides the best opportunity for breaking
the regulatory and judicial gridlock that exists in the United States telecommunications
industry by enabling the Courts to do what is correct: eliminate prohibitions
against RBOC entry into the long-distance business. Doing so will not only
stimulate competition in the interLATA market but also yield some old-fashioned
integration economies that will assist the development of the Information
Superhighway.
{69} It has long been recognized that economies
of scope exist between the local and long-distance businesses. Indeed,
Professor Baumol discusses "efficiencies derived from coordinated operation
of an integrated network."[96]
Network-wide planning decisions "make production less costly when local
and long-distance operations are contained within one firm."[97]
The RBOCs will recognize scope economies if waivers are granted since they
will be able to use many of their embedded facilities to provide long-distance
services. Excess capacity can thus be used to provide service that others
might provide by making new investments. Savings in investment are thus
recognized to the ultimate benefit of society. Likewise, with the CFP,
IXCs and others will be able to recognize scope economies in providing
local service.
{70} Of perhaps greater quantitative significance are the economies that come from systems innovation which will be facilitated once interLATA waivers are granted. Innovation facilitates non-price competition in the form of new services in addition to price competition. Economists recognize that the MFJ restrictions "ignore the foregone consumers' surplus [that would be available] from services that the RBOCs would and might offer but for the restrictions."[98]
{71} The restriction on the RBOCs from operating interLATA vitiates their capacity to deliver services customers want and in the manner customers prefer. LATAs are purely artificial constructs which make no geographical, technological, or organizational sense.[99] InterLATA restrictions are a primary reason for the slow adoption and diffusion of mobile data services, ISDN,[100] voice messaging, and other network services.
{72} The granting of interLATA waivers will increase the value to customers of many broadband services. Remote teaching via videoconference is such an opportunity. Because many businesses and educational institutions (e.g., Ford, GM, and the University of Illinois) have facilities which span several LATAs, the waivers will permit the local telephone company to provide these services on a company-wide or institution-wide basis. Moreover, because many network services have high fixed costs, the removal of interLATA restrictions will at minimum increase the size of the potential customer base and bring forward services which involve significant scale economies and network externalities.
{73} Furthermore, the removal of the interLATA restriction would enhance the efficiency of RBOC services as they are currently configured, leading to lower prices and better services. Examples include Centrex, Caller ID, and enhanced facsimile services already offered by the RBOCs. Centrex is a service offering which competes with PBX equipment. Regional Centrex is a complete private network for a customer with locations in multiple LATAs connected via long-distance services. The interLATA restriction prevents the RBOCs from offering regional Centrex services.[101] If the RBOCs are able to offer the one-stop shopping for customers that regional Centrex entails, they could provide an important competitive alternative to the PBX-based private networks that have proliferated in the United States. Again, this increase in competition will reduce the costs of service and stimulate service innovation.
{74} Removal of the interLATA restriction would also facilitate the commercialization of enhanced facsimile services. At present, a RBOC wishing to compete in such services has to install equipment in every LATA where service is desired. LATAs with a small amount of potential usage are not economic to serve under this arrangement but could be more efficiently served from another larger LATA with higher volumes. This innovative service is thus not available to customers who would have it but for the interLATA restriction.
{75} The social cost imposed by the interLATA restrictions can be further illustrated by one of the RBOC's, in this case Ameritech's, abortive efforts to provide voice mail services through its acquisition of Tigon.[102] Ameritech was unable to achieve the benefits of integration that were necessary to profitably operate Tigon's voice mail service. MFJ restrictions have increased Ameritech's costs and lowered its revenues, thereby crimping the competitive operation of its business.[103]
{76} Voice mail services such as Tigon are sold with two main components: mailboxes and an "800" Telephone access. Because Ameritech could not resell or provide long-distance services and its competitors could, Ameritech could not factor in "800" service resale into its prices for voice mail services.[104] This meant that Ameritech could not take advantage of buying discounted "800" service and passing lower prices onto its customers. Ameritech could only sell the mailbox. This allowed Tigon's major competitors to heavily discount basic mailbox fees and earn healthy margins on 800 resale. Tigon, because of the interLATA restriction, did not have this pricing flexibility and as a result, had to either accept overall margins below those of its rivals or lose sales. More importantly, Tigon's customers were denied the price reductions others enjoyed through volume discounts.
{77} Tigon was further disadvantaged by the confusion created among less sophisticated buyers. While Ameritech's Tigon customers were forced to purchase their own "800" services separate from the Tigon mailbox, a competitor's customers would find that feature bundled into its price for basic voice mail service. This created customer confusion, as competitors exploited the notion that with the Ameritech services the customer had to "buy more." Another disadvantage was Ameritech's inability to achieve scale and scope efficiencies. The MFJ prohibition and the attendant customer confusion forced Tigon to build a higher cost network than its competitors. In many instances, Ameritech erected a database in separate LATAs, even when engineering principles and marketing data would indicate the superiority of an alternative, central facilities strategy. As a consequence, it had to choose between not optimizing its network design or serving a more limited market area than its competitors. The Tigon example highlights the fact that artificial regulatory boundaries which cause duplicate investment are a subtle but costly tax on the economy. These real costs and foregone opportunities are no longer acceptable.
{79} One noticeable feature of the telecommunications competitive landscape is the rapid pace at which events unfold. Since the presentation of this article in September, 1994, Ameritech's Customer First Plan (CFP) has received the enthusiastic support of the Department of Justice (DOJ).[106] The DOJ has indicated that it will file a motion in support of the experimental implementation of CFP when Ameritech applies to United States District Judge Harold Greene for a waiver.[107] If the waiver is granted, we will see first hand whether the conclusions of this paper are correct.
{80} Under the terms of the proposed order negotiated between the DOJ and Ameritech, Ameritech would be allowed to offer interLATA service on a provisional basis from the LATAs encompassing the Chicago, Illinois and Grand Rapids, Michigan areas. If the Order is approved by the Court, Ameritech will not be allowed to enter into interLATA until the DOJ determines that "actual" competitive conditions exist in local markets within the waiver area.[108] Once Ameritech begins operation as an independent carrier, the DOJ will continue to monitor the trial with a wide range of supervisory powers and will maintain the authority to terminate the experiment at any time.[109]
{81} In the past six months, there have been a number of significant competitive developments in both Chicago and Grand Rapids. In Chicago, two competitive access providers, MFS Communications and Teleport, have been certified to offer local exchange service, and a third, MCI Metro, has applied to do the same.[110] City Signal, Inc., owned by Teledial America, already provides competitive local phone services in both Grand Rapids and Detroit.[111] Other alternative providers of local service are entering, including cable companies. Chicago is home of two separate tests of cable-based telephone service. MCI and Jones Lightwave intend to test linking a few residents in Chicago suburbs to MCI's long distance service.[112] Motorola, Inc., TCI, and Teleport Communications Group are providing local phone service over cable lines on a test basis in Arlington Heights, Illinois.[113]
{82} In addition to facing heightened competition in local exchange, Ameritech will be operating under additional guidelines that were not elements of the original CFP. Foremost, Ameritech is required to operate its interexchange business as a separate subsidiary.[114] Although I have never endorsed the idea that Ameritech has either the incentive or the ability to engage in cross-subsidization, this structural separation offers ironclad protection against such a possibility.
{83} Developments over the last six months have confirmed many of the propositions advanced in this paper and elsewhere. The local exchange is not a natural monopoly and indeed stands on the brink of an explosion in the number of competitive alternatives. The proposed DOJ order safeguards any residual possibility of competitive harm by adopting the protections of the CFP, by calling for active monitoring of the local exchange market, and by requiring the structural separation of Ameritech's new long-distance business from its existing local business.
{84} In sum, if the courts approve Ameritech's
CFP in Illinois, we will shortly witness a major step in the structural
reform of the United States telecommunications industry.