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Appendix E On Fairness and Self-Serving Biases in the Privatization of Environmental Data Edward E. Zajac University of Arizona Note: The committee commissioned the following paper to explore an aspect of government-private sector interactions that is commonly overlooked—the issue of fairness. The paper summarizes the current research in this area, and its application to the weather and climate enterprise is discussed inChapter 4. Dr. Zajac’s views, as expressed below, may not always reflect the views of the committee or vice versa. INTRODUCTION The National Research Council (NRC) report Resolving Conflicts Arising from the Privatization of Environmental Data1 does a beautiful job of identifying the main stakeholders in the privatization process, analyzing their interests and their probable gains and losses from privatization, and describing how the creation and distribution of the results of research should be structured in order to achieve economic (allocative) efficiency. The report, however, does not attempt to apply the fruits of fairness and self-service (denial) research to the problem of conflict prevention and resolution. This may be a significant omission. There is in fact a large and rapidly growing literature on both fairness and self-serving behavior. I refer here to research that develops positive theories of fairness and self-service. Positive theories attempt to describe and analyze what is, as contrasted to normative moral theories that prescribe what ought to be. The positive theories are still evolving, and much remains to be done. Nonetheless, even in their present state, the theories have predictive power—not the power of the laws of physics, but often sufficient power to be useful. If nothing more, the theories give a vocabulary of words and concepts that can facilitate communication among stakeholders. They may thus streamline and elevate the debate. It would be ideal if elevating the debate were to prevent conflicts 1 National Research Council, 2001, Resolving Conflicts Arising from the Privatization of Environmental Data, National Academy Press, Washington, D.C., 99 pp.
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from arising in the first place. Perhaps this is too much to ask, but we can hope to minimize conflicts and, should they arise, to resolve them more rapidly and with less waste of resources on counterproductive argument and maneuvering. Research on fairness and self-service was started at least four decades ago by psychologists with their work on equity theory.2 In the last two decades, experimental economists have mounted a large fairness research effort, motivated by early experiments in which humans failed to show completely selfish, self-interested behavior—the behavior assumed by economic theory.3 At the same time, researchers from every branch of the social sciences have made and continue to make contributions to the theory. The main research tools have been surveys, case studies, laboratory studies using human subjects, and development of theory that is informed by the empirical findings and stimulated by them. In this paper, I give a very brief summary in the next two sections of the present state of theories of fairness and self-service. I do not claim that the summary is complete; rather it reflects my own view and research interests. Other fairness researchers’ summaries might have a different emphasis.4 The last section discusses the implications of the theory for policy design and implementation, first pointing out that privatization leads to a problem 2 See, for example, E. Walster, G.W. Walster, and E. Berscheid, 1978, Equity Theory and Research, Allyn and Bacon, Boston, 312 pp. 3 A pioneering work that greatly stimulated economists’ interest in fairness or distributive justice is W. Güth, R. Schmittberger, and B. Schwarze, 1982, An experimental analysis of ultimatum bargaining, Journal of Economic Behavior and Organization, v. 3, p. 362-388. 4 For other taxonomies of fairness principles, see H.P. Young, 1994, Equity: In Theory and Practice, Princeton University Press, Princeton, N.J., 253 pp. (6 axioms as the basis of a mathematical characterization of distributive justice); B.H. Sheppard, R.J. Lewicki, and J.W. Minton, 1992, Organizational Justice: The Search for Fairness in the Workplace, Lexington Books, Cambridge, Mass., 228 pp. (18 principles of distributive, procedural, and systemwide justice); and S.W. Gilliland, 1993, The perceived fairness of selection systems: An organizational justice perspective, Academy of Management Review, v. 18, p. 694-734 (9 procedural rules that enhance the perceived fairness of selection procedures). The reader interested in positive fairness research can also find more in M. Bar-Hillel and M. Yaari, 1984, On dividing justly, Social Choice and Welfare, v. 1, p. 1-24; R. Cropanzano and J. Greenberg, 1997, Progress in organizational justice: Tunneling through the maze, in International Review of Industrial and Organizational Psychology, v. 12, C.L. Cooper and I.T. Robertson, eds., John Wiley, New York, pp. 317-370; J. Elster, ed., 1995, Local Justice in America, Russell Sage Foundation, New York, pp. 81-151; J. Greenberg, 1996, The Quest for Justice on the Job: Essays and Experiments, Sage, Thousand Oaks, Calif., 428 pp.; G. Jasso, 1990, Methods for the theoretical and empirical analysis of comparison processes, in Sociological Methodology, C. Clogg, ed., American Sociological Association, Washington, D.C., pp. 369-419. It should be noted in passing that there is also a large academic literature on negotiation, arbitration, and conflict resolution, per se (see, for example, M. Deutsch and P.T. Coleman, 2000, The Handbook of Conflict Resolution: Theory and Practice, Jossey-Bass, San Francisco, 649 pp.
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of institutional design and then taking up “political fairness games.” These are the political controversies that can arise when stakeholders try to convince regulators, legislators, or the courts of the fairness of their positions and the unfairness of their rivals’ pleadings. As illustrations, I give very brief histories of two such games in telephony: (1) the deregulation of long-distance phone service and (2) the 14-year process of introducing cellular phone service in the United States. Finally, I discuss how the results of fairness and self-service research might be applied to policy design. THE STRUCTURE OF FAIRNESS5 The Formal Principle of Distributive Justice; Material Principles If you and I happen to find $400 on the street, we would probably divide it equally into $200 for you and $200 for me. On the other hand, if you put in three hours of work and I one hour to make something that we sell for $400, we would probably agree that you should get $300 and I $100. Finally, suppose we are given a frosted cake. Further, suppose you have a disease that requires you to consume three times as much sugar as a normal human being and I am normal. Then, I probably would not object to your having three-quarters of the cake while I had one-quarter of it. This example illustrates an important normative principle that goes back at least to Aristotle. We divided the $400 based on our claims to it. When we happened to find it on the street, we had equal claims; when we mutually made something, our claims were in proportion to our work effort; when we received the cake, our claims were based on different needs for sugar. The principle is variously called the Formal or Aristotelian Principle of Distributive Justice. A succinct statement of it is:6 Equals should be treated equally and unequals unequally, in proportion to relevant similarities and differences. The important point is that you should not divide a resource arbitrarily, but rather in proportion to the claims on it. Further, the claims should not be arbitrary, but should be based on something relevant. Left wide open is what the terms equal, unequal, and similarities and differences mean. These are usually clarified by the application of material principles of distributive justice. Research on positive theories of fairness and distribu- 5 The material in this and the following section of this paper has been adapted from E.E. Zajac, 2002, What fairness-and-denial research could have told the Florida Supreme Court (and can tell the rest of us), Independent Review, v. VI, p. 377-397. 6 This form of the Formal Principle is taken from A.E. Buchanan and D. Mathieu, 1986, Philosophy and justice, in Justice: Views from the Social Sciences, R.L. Cohen, ed., Plenum Press, New York, pp. 11-45.
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tive justice consists mainly of trying to understand and explain under what circumstances human beings apply which material principle. We have already encountered a couple of material principles in our example—desert (in the case of division in proportion to work effort) and need (in the case of the division of the cake). However, there are many other material principles, for example, merit (civil service jobs are often awarded on the basis of scores on competitive examinations); seniority (many union contracts require that pay be based on length of time on the job); and affirmative action, which has focused on the material principles of ethnicity, age, and sex. Other material principles focus on the fairness of the procedures for dividing a resource, in particular that the procedures should be nondiscretionary—the rules for division and distribution of a resource should be set in advance and not deviated from, nonmanipulative—the rules should not be subject to strategic manipulation, and noncoercive—the divider of the resource should not have undue power. Effects of History Still other material principles are based on the effects of history. A common notion is that one is entitled to maintain a beneficial status quo established historically—in other terms, that one has a status quo property right or entitlement to something simply by virtue of having enjoyed it in the past. When a profession is first licensed, it is common for the extant practitioners to be “grandfathered-in” and exempted from the educational achievements and examinations required of new licensees. Likewise, when a new building code is adopted, existing buildings are often similarly grandfathered-in, sometimes with tragic consequences when an earthquake or hurricane occurs. Rent control has existed in Paris and London since World War I and in New York City since World War II. Controlled rents are often a fraction of market value, yet tenants feel strongly that they are entitled to them. Renters react to landlord pleadings before the New York rent control authority with derision and sometimes with violence. In their seminal article in the American Economic Review, based on extensive surveys, Kahneman, Knetsch, and Thaler formulated an entitlement theory for business transactions based on a reference transaction determined by history.7 Their data led them to conclude that transactors 7 D. Kahneman, J.L. Knetsch, and R. Thaler, 1986, Fairness as a constraint on profit seeking: Entitlements in the market, American Economic Review, v. 76, p. 728-741.
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feel that they have an entitlement to a historically set reference wage or price and that firms are entitled to a reference profit. Thus, after a severe snowstorm, customers will feel it is unfair if the town’s hardware stores triple the price of snow shovels. Likewise, a big employer in a small town may go bankrupt and flood the town with skilled employees who lower market wages. Respondents in their surveys felt it would be unfair for the remaining employers to lower wages to market levels. On the other hand, in other contexts, entitlements or status quo property rights are specifically not honored. Last year’s Super Bowl winner has no special status in this year’s NFL season, and, in general, athletic contests pay no attention to history. Everyone is supposedly considered equal before the law, and one’s previous criminal history, whether exemplary or despicable, is often excluded from the evidentiary record in a criminal trial. Often by law the winner of government contracts is the lowest bidder, regardless of the history of the bidder’s previous performance record, many times to the regret of the agency letting the contract.8 Thus, there are many material principles of justice—some dependent on history, others not. The above list is in fact not meant to be exhaustive, especially since material principles overlap. Seniority can be viewed as a combination of a status quo property right and desert, in that those who provide long and faithful service for an employer deserve more pay than those with short service. Likewise, status quo property rights are themselves sometimes a combination of historical entitlement and desert. Frontier squatters in the early nineteenth century United States established rights to a piece of land by carving their initials on the bark of a tree on the land (“tomahawk rights”), by planting a crop on it (“corn rights”), or by building a structure on it (“cabin rights”). The more years that crops were planted and the more numerous and extensive the structures, the greater is the element of desert in the squatter’s claim.9 An open research question is, Does there exist a minimum, non-over-lapping set of material principles that captures all of human fairness behavior, and if the set does exist, what material principles comprise it?10 8 For more on status quo property rights, see J. Elster, ed., 1995, Local Justice in America, Russell Sage Foundation, New York, pp. 81-151; R.M. Isaac, D. Mathieu, and E.E. Zajac, 1991, Institutional framing and perceptions of fairness, Constitutional Political Economy, v. 2, p. 329-370; E.E. Zajac, 1995, Political Economy of Fairness, MIT Press, Cambridge, Mass., 325 pp.; and E. Schlicht, 1998, On Custom in the Economy, Clarendon Press, Oxford, U.K., pp. 111-115. 9 For a recent discussion of the establishment of squatters’ rights on the early nineteenth century American frontier, see H. DeSoto, 2000, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, Basic Books, New York, 276 pp. 10 E. Schlicht (On Custom in the Economy, Clarendon Press, Oxford, U.K., pp. 111-115, 1998) advances a general theory of custom formation and the role of customs that subsumes
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Contextual Effects or Institutional Framing The fact that in some contexts history plays a crucial role in determining what is fair, while in other contexts it plays no role whatsoever, highlights an important aspect of fairness: context or the institutional setting frames how we view fairness. In the extreme, we may have the situation that what is considered fair in one context or institution may be considered unfair in another. The literature on fairness repeatedly stresses this point. In economics, we have the example of human subjects having different views of fairness in experiments involving market and non-market settings. In such experiments, the subjects’ task is to divide some economic pie, with payoffs to them in dollars. If the experiment is in a market-like setting and has a large number of subjects (say more than 20) in impersonal transactions (say by means of computers), the fairness of the varying payoffs the subjects receive almost never comes up. On the other hand, in experiments with a few subjects (say fewer than a half dozen) in a non-market setting and with face-to-face interactions, the fairness of the payoffs is very likely to come up. Little is known about in-between cases. This reflects what we see in the real world. If we buy groceries at the supermarket, or a home in our community, or stocks through our broker, the fairness of what we paid is rarely an issue as long as the amount is in line with market prices. In market transactions, something impersonal— money—is exchanged for something tangible and material. Money depersonalizes the transaction. It is a different story, however, when it comes to the division of assets in a divorce, to the assignment of hotel rooms to members of a tour group, or to the allocation of offices among faculty members. Allocation decisions such as these—ones that involve a small number of persons in face-to-face interactions in a non-market setting—can be intensely personal, and whether or not the allocation is fair can be the central issue. Economics is not the only discipline to stress context effects in the determination of what is fair.11 In philosophy, we have, for example, fairness and self-serving behavior. He adduces evidence, based on an extensive survey of the psychological and biological literature, that human beings have an innate “rule preference”— “a preference for psychological meaningful, or clear rules.” He further argues that rule prefer-ence is the motivational force for custom formation. Fairness norms are special cases of customs, and Schlicht’s theory may provide the desired parsimonious explanation of fairness principles. His theory is, however, very new and its general acceptance is still in the offing. 11 For more on context effects or “institutional framing” see R.M. Isaac, D. Mathieu, and E.E. Zajac, 1991, Institutional framing and perceptions of fairness, Constitutional Political Economy, v. 2, p. 329-370, and E. Schlicht, 1998, On Custom in the Economy, Clarendon Press, Oxford, U.K., pp. 69-86.
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Michael Walzer’s Spheres of Justice, which stresses that equality will and should be interpreted differently in different contexts: Thus, citizen X may be chosen over citizen Y for political office, and then the two of them will be unequal in the sphere of politics. But they will not be unequal generally so long as X’s office gives him no advantages of Y in any other sphere—superior medical care, access to better schools for his children, entrepreneurial opportunities, and so on.12 Likewise, from the psychological literature, we have the following statement by J. Greenberg: What makes a set of questions appropriate in one context may not make them equally appropriate in another. Questions about justice should be carefully matched to the context of interest.13 Fairness Overdetermination Thus, fairness principles are context dependent, can overlap, and can even be contradictory. The principles can be formally applied, as when an organization adopts Robert’s Rules of Order, or can be informally observed, as when people in England automatically form queues at bus stops. They can also be culturally dependent—Germans don’t form queues at bus stops. There are thus typically many more fairness principles than an organization or institution needs to govern its functioning—what Elster calls “fairness overdetermination.”14 Formally or informally, the institution will usually settle on an adequate number of fairness principles to use for its governance, ignore the rest, and operate peacefully in a governance equilibrium year after year without incident. All this may change if big external effects give some members of an institution opportunities for gain. Fairness overdetermination may give potential gainers the weapons they need. They may resurrect dormant fairness principles, using those that allow them to claim that they are being treated unfairly. 12 M. Walzer, 1983, Spheres of Justice: A Defense of Pluralism and Equality, Basic Books, New York, p. 19. 13 J. Greenberg, 1996, The Quest for Justice on the Job: Essays and Experiments, Sage, Thousand Oaks, Calif., p. 402. 14 J. Elster, ed., 1995, Local Justice in America, Russell Sage Foundation, New York, pp. 81-151.
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Fairness Versus Unfairness What is fairness? Well, unless you are going to take the position that everyone should earn the same thing, fairness is going to be arbitrary. William F. Buckley (1992)15 Given the above discussion, Buckley’s view is hardly surprising and, in fact, is common. Nonetheless, it is not quite correct. What we consider fair is obviously not completely arbitrary. The salaries within an organization could not be based on the color of an employee’s eyes, nor could income taxes be based on a citizen’s month of birth. In both cases, society would demand that salaries or income taxes be based on principles that were considered “fair.” Yet Buckley’s view is correct in that the complexity of the structure of fairness leaves room for much arbitrariness in its application. If Buckley’s view is common, so is outrage expressed over obviously unfair treatment, as undoubtedly would be the reaction if one indeed tried to apportion salaries by color of eyes and income taxes by month of birth. How can the public hold such contradictory views—that fairness is arbitrary on one hand, while unfairnesses are obvious on the other? These views are not as contradictory as they may seem. Unless we are trained linguists, we are unable to describe the complete structure of English grammar. Yet when a foreigner makes a grammatical mistake in speaking English, we will probably recognize it immediately. Likewise, unless we are medical professionals, we will not understand in detail how the biology, physiology, and anatomy of the human body interact. Yet, we know when we feel pain or otherwise feel not quite “normal.” The point is that we encounter complex patterns in all phases of our daily lives, patterns that we rarely are able to describe in detail. We are, however, much more readily able to detect that something in the pattern has changed and has gone awry. So it is with fairness. Unless we specialize in studying fairness, we are likely to be unable to explain its structure, but we know when we have been “screwed,” “shafted,” or “taken to the cleaners” or, in a competition with rivals, when there is an outrageous lack of a “level playing field.” Contract-Breaking Behavior Perceived unfair treatment is in fact a great energizer, and the rectification of unfairness strongly motivates the creation of new policy. Often the feeling of unfair treatment is the feeling that a contract, implicit or explicit, 15 W. Buckley, 1992, If candidates say “fairness” grab your wallet and hold on, Tucson (Arizona) Citizen, March 17.
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has been broken. The perceived unfairness of contract-breaking behavior seems to be universal and important. SELF-SERVING BEHAVIOR AND ADAM SMITH’S “VEIL OF SELF-DELUSION” He is…bold who does not hesitate to pull off the veil of self-delusion which covers from his view the deformities of his own conduct…. This self-deceit, this fatal weakness of mankind, is the source of half the disorders of human life. Adam Smith, The Theory of Moral Sentiments (1759)16 Theory Leon Festinger’s 1957 book A Theory of Cognitive Dissonance is still a seminal work. In it Festinger laid out a general theory of the rejection of reality or, for want of a better term, of “denial.” Somewhat oversimplified, his theory goes like this: Our minds hold simplified models of reality, models that we are loath to abandon. We do not welcome evidence that contradicts these models and thus leads to “cognitive dissonance.” We try to reduce this dissonance in various ways, perhaps by rejecting the contradictory evidence or perhaps by ignoring it while we find more evidence to support the models in our minds. In extreme cases we might even admit to ourselves that our models are wrong. Yet this may be rare, and often, especially when it suits our purposes, we reject reality with great conviction. We quickly pull Adam Smith’s “veil of self-delusion” over our eyes. According to news accounts, Timothy McVeigh, the “Oklahoma City Bomber,” went to his execution convinced that his killing of 168 innocent people was totally justified.17 As I understand it, not all psychologists accept Festinger’s theory, at least not completely. Many alternative theories may explain denial. For example, prison inmates are notorious for pleading that they are innocent or, even if guilty, that they have been unjustly incarcerated because of extenuating circumstances. Their behavior can be explained by the theory of cognitive dissonance, but may simply be based on their belief that their protestations might somehow shorten their sentences. 16 A. Smith, 1759, The Theory of Moral Sentiments, reprinted in 1976 by Liberty Classics, Indianapolis, p. 263. 17 Associated Press, 2001, McVeigh Says He’s Sorry for Deaths, June 9.
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Empirical Evidence of Self-Serving Behavior Many of the above problems can be circumvented by narrowing the focus to test for the existence of self-serving behavior. Using surveys and controlled laboratory experiments, a large body of psychological research takes this approach. It demonstrates not only individual self-serving biases but group self-serving biases as well. Some of the results cited by Babcock and Lowenstein are the following: individual self-serving bias: Over half of survey respondents typically rate themselves in the top 50 percent of drivers,…ethics,…managerial prowess,…productivity,…health,…and a variety of desirable skills. When married couples estimate the fraction of various household tasks they are responsible for, their estimates typically add to more than 100 percent. People also tend to attribute their successes to ability and skill but their failures to bad luck. group self-serving bias: [Princeton and Dartmouth] students viewed a film of [a football] game and counted the number of penalties committed by both teams. Princeton students saw the Dartmouth team commit twice as many flagrant penalties and three times as many mild penalties as their own team. Dartmouth students, on the other hand, recorded an approximately equal number of penalties by both teams. While the truth probably lies somewhere in between, the researchers concluded that it was as if the two groups of students “saw a different game.”18 The interested reader can find a recent survey of this literature and the general literature on cognitive dissonance in Konow (2000).19 IMPLICATIONS Privatization Means a Problem of Institutional Design The privatization of environmental data will create new institutions. Thus, we are faced with a problem of institutional design. The trick is to 18 L. Babcock and G. Lowenstein, 1997, Explaining bargaining impasse: The role of self-serving biases, Journal of Economic Perspectives, v. 11, p. 111. 19 J. Konow, 2000, Fair shares: Accountability and cognitive dissonance in allocation decisions, American Economic Review, v. 90, p. 1072-1091.
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design the institutions so that the individuals and groups of individuals participating in the institutions will feel that they are being treated fairly. Achieving this goal is not easy. Fairness is a complex matter; moreover, it is context or institutionally dependent. This can lead to overlapping and even contradictory fairness principles. In addition, institutional design must cope not only with fairness but also with the human tendency for self-serving behavior and the rejection of evidence that does not accord with self-interest. Poor institutional design that ignores fairness and self-service can result in counterproductive resource waste. An often-heard joke is: “X and Y’s lawyers finally agreed on a divorce settlement. They had to—their fees had wiped out the assets in X and Y’s marriage, and there was nothing left for them to take.” Unfortunately, even when lawyers work hard to avoid this disastrously counterproductive outcome, it can occur. Spouses may refuse to budge from demands for what each considers a “fair” settlement, and having large sums eaten up unnecessarily in lawyers’ fees is not confined to divorces. Newspapers periodically report litigants spending thousands on litigation to settle a disagreement over a matter in which a few dollars are at stake. Political Fairness Games and Two Case Studies Fairness fights are also not confined to litigants in court battles. In the political arena, interest groups typically try to convince regulators or legislators of the righteousness of their cause and of the unfairness of the pleadings of rival interest groups. All of the groups involved will probably have had no trouble in finding “public interest” fairness arguments to buttress their pleadings. What is more, they may have convinced themselves that they are in fact acting in the public interest and not in their own interests. The result is what might be called “political fairness games” that are played out in the public arena, often with extensive media coverage. Most importantly, the games often result in a massive waste of resources. In my experience in telecommunications, two dramatic examples come to mind—the deregulation of long-distance telephone service and the development of cellular mobile telephony. Both occurred in the 1970s and early 1980s, and both perhaps had elements of the controversies involved in the privatization of environmental data. I give a brief history of each, followed by a discussion of what might have been done to mitigate the deleterious effects of the fairness fights.20 20 The deregulation of long distance and the development of cellular telephony both occurred during my 30 years of employment at Bell Laboratories (1954-1984). To present their histories as objectively as possible, I have relied primarily on published accounts of events rather than on my memory of them.
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Deregulation of Long-Distance Telephone Service21 In 1971 the Federal Communications Commission’s (FCC’s) Specialized Common Carrier decision allowed MCI to provide long-distance telephone service between St. Louis and Chicago. The rationale was that MCI would provide a service not available from AT&T—cheap but low-quality service. MCI would thus not disturb AT&T’s “natural” monopoly over the services it provided. MCI would also therefore not disturb AT&T’s regulation by the FCC. The decision, of course, introduced the camel’s nose into the tent, and MCI started an aggressive campaign to expand from low-quality but cheap service to service of the same quality and extent as that provided by Bell. During this period, AT&T could be viewed as a quasi-public corporation. The rates it charged were not those of a rapacious monopolist. Rather, they were set by regulators so as to yield AT&T’s shareholders a “fair return on the fair value of AT&T’s assets.” AT&T also supported Bell Labs, an R&D establishment of more than 24,000 employees. Under a 1956 antitrust consent decree, Bell Labs’ patents had to be licensed to anyone at “fair” rates, usually interpreted to mean a nominal 2-4% royalty on the revenues that the patent license generated. Since its inception, Bell Labs had done the bulk of the nation’s telecommunications research and continued to do so after long-distance service was deregulated. Thus it, too, could be viewed as a quasi-public agency, playing a role in telecommunications analogous to that played by government research entities in other areas. AT&T’s management fiercely resisted attempts by MCI, and later by other common carriers, to invade its turf. AT&T viewed its telephone monopoly as a sacred trust that conferred on AT&T the duty to provide ultrareliable, high-quality service at affordable prices—“the best telephone service in the world.”22 MCI was considered an upstart with no understanding of this trust and duty, bent only on crass maximization of its profits. The FCC largely supported AT&T’s position. This forced MCI to go to the courts to seek relief (MCI got to be known as “a law firm with an 21 For a more extensive discussion of the history of the long-distance controversy, see G.R. Faulhaber, 1987, Telecommunications in Turmoil: Technology and Public Policy, Ballinger, Cambridge, Mass., 186 pp. 22 E.E. Zajac, 1990, Technological winds of creation and destruction in telecommunications: A case study, in Evolving Technology and Market Structure: Studies in Schumpeterian Economics, A. Heertje and M. Perlman, eds., University of Michigan Press, Ann Arbor, 351 pp., describes the AT&T-Bell Labs mind-set during the period when it had a monopoly on long-distance service.
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antenna”), as it expanded first from private line service between St. Louis and Chicago to private line service elsewhere, then to interconnection with AT&T’s network, and finally to the provision of switched service throughout the United States. In these battles, AT&T of course invoked its status quo property rights, while MCI claimed that AT&T’s obstructionist tactics were denying the public the benefits of competition. A basic issue was the allocation of AT&T’s joint and common costs between the branches of AT&T that had no competition and continued to be regulated as before 1971 and the branches that were in competition, first with MCI and later with other rivals as well. On the surface, cost allocation would seem to be a trivial issue. In fact, it presents subtle and difficult definitional and mathematical problems, and is a bottomless pit of controversy in both the economics and the accounting professions. The cost allocation problem led to charges by Bell rivals that Bell’s regulated services were unfairly cross-subsidizing its unregulated competitive services and that by means of such cross-subsidization AT&T was engaging in “predatory pricing.”23 AT&T and its rivals incessantly trotted out fairness arguments to demonstrate that they did not face a level playing field in the competition for the long-distance market. The charges provided fuel for political fairness games before the FCC and Congress, as well as for some legal fairness games played out before the courts (MCI won most of the games). Discussion of the 1970s Long-Distance Telephony Fairness Game With hindsight, had the FCC been more forceful and enthusiastic in embracing and encouraging competition in long-distance telephony, much of the resource waste that occurred could have been avoided. In the terminology and ideas of this paper, such action would have changed the context or “institutional frame” of the fairness fights. As it was, the FCC adopted a gradualist approach, putting its toe in the water with the 1971 Specialized Common Carrier decision and half-heartedly accepting court decisions that, over many years, allowed MCI more and more entry into the long-distance business. The Civil Aeronautics Board (CAB) under Chair Alfred E. Kahn and Vice Chair Elizabeth E. Bailey in the late 1970s is a model of the sort of decisive behavior that I have in mind. In a few years, they deregulated the airlines and closed down the CAB. Kahn and Bailey were trained economists who specialized in regulation. They had the courage of their convic- 23 For an introduction to the theory of cross-subsidization and predatory pricing, see E.E. Zajac, 1995, Political Economy of Fairness, MIT Press, Cambridge, Mass., pp. 203-226.
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tions, and their training and vast regulatory experience motivated them to acts that non-economists considered to be outrageously bold and that lawyers thought outrageously illegal. Perhaps it is too much to expect an FCC composed of the usual political appointees to act similarly. In addition, an institutional innovation, facilitated by the breakup of AT&T in 1984, finally solved the cost allocation dilemma. Namely, the FCC abandoned rate of return regulation of AT&T in favor of price cap regulation, a regulatory method that largely avoided the calculation of costs. The price cap innovation could have been adopted much earlier but, unfortunately, was not.24 To my knowledge, no one has estimated the magnitude of the undoubtedly enormous cost to U.S. society of the long-distance telephone service fairness games of the 1970s and early 1980s. Cellular Mobile Telephony25 The cellular mobile telephony concept envisions an antenna within each cell of a “beehive,” with all of the antennae connected to a central computer. As the customer drives from Cell A into Cell B, the computer hands him off from the antenna in A to that in B. The design, of murky origins, promised great efficiency because the same bandwidth could be used by nonadjacent cells. This meant that it could be reused an estimated 16 to 64 times in a given market. Until the late 1960s, the cellular concept was mainly a theoretical curiosity because of lack of availability of spectrum for mobile telephony. Ten percent of the spectrum that was available was allotted to AT&T as a “wireline common carrier” (WLCC) and 90% to about 500 “radio common carriers” (RCCs). The latter were mostly small “ma and pa” operations. In addition to the common carriers, specialized groups, mostly police and fire departments and taxicab companies, had their own mobile telephone service. Prior to the introduction of cellular telephony, a land mobile customer connected by radio phone to an operator who patched him into the tele- 24 Ironically, the Telecommunications Act of 1996 and its interpretation and implementation by the FCC reintroduced the specific consideration of costs into the regulation of telecommunications carriers. As was to be expected, this reignited costing methodology controversies. These ended up at the U.S. Supreme Court, with the Court issuing an extensive opinion on telecommunications costing methodology on May 13, 2002. Maybe the Court’s decision (U.S. Supreme Court, 2002, Verizon Communications, Inc., et al. v. Federal Communications Commission et al., 535 U.S., May 13, 2002) will resolve the controversies once and for all, but I doubt it. 25 The history of cellular mobile telephony recounted here is abstracted from K.E. Hardman, 1982, A primer on cellular mobile telephone systems, Federal Bar News & Journal, v. 29, p. 385-391.
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phone network. By 1968, such land mobile service was saturated, with long waiting lists of customers desiring to subscribe. In response, the FCC initiated hearings, proposing to provide additional spectrum to land mobile by robbing it from the band allotted for ultrahigh-frequency (UHF) television stations and also to consider allocating the robbed spectrum to a cellular design based on preliminary AT&T studies. There rapidly emerged a furious political fairness game, fought principally before the Federal Communications Commission, but with trips to the courts. The FCC’s initial position was that only AT&T and other WLCCs had the technical capability to develop and deploy the cellular design. The FCC consequently proposed allotting the entire robbed part of the UHF-TV spectrum to them. The RCCs objected vigorously, invoking their status quo property rights. Moreover, under the 1956 consent decree, AT&T could not enter the non-Bell market for land mobile hardware. This was the domain principally of Motorola and GE, with 65-70% and 15% market share, respectively. Under the FCC’s proposal, AT&T would be the sole buyer in the cellular hardware market and could make hardware suppliers dance to its tune. In particular, AT&T could put Motorola in competition with Japanese suppliers. Needless to say, Motorola jumped into the fray as well. Thus, as the FCC struggled with the problem of relieving the saturation of the land mobile telephone market, it had four major stakeholder groups with strong status quo property rights to contend with—the WLCCs, the RCCs, the broadcast industry, and Motorola—and numerous minor stakeholders. The resulting political fairness game played out mostly before the FCC but with some trips to the courts. Approval of the deployment of cellular mobile telephony occurred only in 1982, 14 years after the FCC first contemplated the cellular design! By then it was available in other parts of the world. When it finally decided to approve cellular, the FCC divided the spectrum made available for it into two parts, awarding one part to the local WLCC and the other to a “qualified” provider. Rohlfs, Jackson, and Kelly estimate that the playing of the political fairness game delayed the U.S. deployment of cellular by a decade or more and cost U.S. society about $86 billion (1991 dollars) in forgone benefits (about 2% of the 1991 U.S. gross national product).26 Discussion of the 1970s Cellular Fairness Game In 1968, when the FCC decided to address the problem of saturation of land mobile telephone service, AT&T had 34,000 mobile customers and 26 J.H. Rohlfs, C.L. Jackson, and T.E. Kelly, 1991, Estimate of the loss to the United States caused by the FCC’s delay in licensing cellular telecommunications, National Economic Research Associates, Inc., White Plains, N.Y., November 8, 24 pp.
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the 500 or so RCCs had 28,000.27 Compared to the long-distance market, which generated roughly half of AT&T’s revenues, land mobile was minuscule. In this regard, land mobile differed profoundly from long distance and in 1968 was probably of minor concern to the FCC. On the other hand, there are many similarities to the situations in which long distance and land mobile found themselves during the 1970s and early 1980s. Both their fates were largely controlled by the FCC, or more precisely by FCC commissioners appointed by the Nixon, Ford, Carter, and Reagan administrations. In both cases, the commissioners regulated by the classic “due process” approach, compared to what might be called the “economic efficiency” approach used by the Kahn-Bailey-dominated CAB of the late 1970s. In regulation, administrative law is the basis of “due process.” As Supreme Court Justice Steven Breyer pointed out: Between 1945 and 1965, by way of reaction to excessive [regulatory] agency freedom, Congress passed and the courts enforced, the federal Administrative Procedures Act (APA). The act imposed certain procedural constraints on federal administrative bodies, whether located in the executive branch or in independent agencies. Its basic object was to achieve “fairness” rather than “control.” It forms the basis of current federal administrative law.28 Needless to say, the APA’s “fair” procedures are abundantly overdetermined in the Elster sense. It is hardly surprising that they triggered lengthy political fairness games in both the deregulation of long distance and the implementation of cellular mobile. As in the case of long distance, the FCC did not act decisively to award property rights to the various claimants as cellular technology unfolded. Perhaps the most striking similarity was the eventual emergence in both cases of an institutional reform that eliminated much of the fairness fighting. In the case of long distance, it was the adoption of price cap regulation. In the case of cellular, it was the use of auctions to allocate spectrum. Economists had proposed auctioning the spectrum for years, but the FCC and the phone companies considered the proposal to be a “looney toons” idea that only out-of-touch-with-reality economists could dream up. However, by the time the FCC was ready to allocate spectrum for a new-generation digital cellular service, spectrum auctions had been successfully conducted in New Zealand and Australia. The FCC, over the vigorous 27 K.E. Hardman, 1982, A primer on cellular mobile telephone systems, Federal Bar News & Journal, v. 29, p. 385-391. 28 S. Breyer, 1982, Regulation and Its Reform, Harvard University Press, Cambridge, Mass., p. 378.
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objections of some members of Congress but with the support of the Clinton administration, opted to auction off the spectrum made available for digital cellular. From a fairness game perspective, this accomplished two things: (1) auctions marketized spectrum allocation, thus minimizing arguments over the fairness of the allocation, and (2) auctions wiped out status quo property rights to the spectrum by introducing an allocation procedure that, from a political standpoint, was considered more fair than one based on status quo property rights. The FCC could have adopted spectrum auctions just as well in 1968, when it first contemplated cellular mobile telephony, as it did almost 30 years later. Applying the Results of Fairness and Self-Service Research The results of research outlined in earlier sections say that we can expect the following in the privatization of environmental data: stakeholders will expect that the Formal Principle will be applied and that material principles of justice will be invoked to give meanings to its vague terms. They will also expect procedures that affect resource allocations to be nondiscretionary, nonmanipulative, and noncoercive. If the stakeholders are benefiting from a status quo, they will likely expect the benefits to continue, unless there is a history of the status quo being ignored. Stakeholders will react quickly to perceived unfair treatment. Moreover, they will be prone to ignore evidence to the contrary and to find evidence to bolster their claims of unfair treatment. Particularly offensive to stakeholders will be a perception that some contract or understanding has been broken. When and if stakeholders feel they have been treated unfairly will depend on the context or institutional setting. This may seem like a gloomy recital. At the same time, it also gives stakeholders in the privatization process a list of things to guard against and to try to forestall. They may even realize that, although it may be easy to feel that they are the victims of an “uneven playing field,” rival stakeholders may have a different view of what constitutes a level playing field. The rivals may be very ingenious in coming up with arguments as to why they are in fact the victims. Furthermore, the rivals may hold these beliefs, as outlandish as they seem, with utmost sincerity. The list suggests several things to do to avoid or, at least minimize, fairness fights. For example, material principles will have to be invoked to give the terms equals, unequals, and relevant similarities and differences specific meanings in the Formal Principle. These meanings should be as clear and unambiguous as possible. Otherwise, some stakeholder group or other will conclude that some contract has been broken and that it is being treated unfairly.
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The fact that context is so important to perceptions of fair or unfair treatment suggests that lack of context definition may lead to fairness fights. However, it also suggests that invoking a specific context may be a tool for forestalling them. For example, in economic experiments regarding “fair” income distribution, there was a large variance in what college student subjects considered a fair minimum family income. When, however, prior to the experiments, the subjects received information on the Census Bureau’s definition of the poverty-level income, the variance narrowed significantly.29 Common knowledge of the poverty-level income gave the students a reference or focal point. This suggests that the more precisely new institutions of privatization are defined, the more likely are fairness fights to be avoided. It also suggests that there is an advantage to using existing institutions that are stable. So, for example, respecting status quo property rights may in fact be a good idea, especially if this allows stakeholders to engage in mutually advantageous (“win-win”) transactions. Schlicht states it well: …costly conflicts and coordination failures can be avoided by adopting some coordination device…. Once a coordination rule is selected for historical or other reasons, it can be sustained by the self-seeking behavior of individuals without any reference to commitment or preference. A coordination rule will remain in place as long as it is advantageous for each individual to observe it, provided the others do the same. This explains persistence. A typical assumption would be that the status quo—the perceived pattern—serves as a focal point, which can be used for coordination purposes.30 Finally, the privatization process should not lose sight of the importance of the institutional design leading to economic efficiency. Elsewhere I have argued that in general designs based solely on fairness, without regard to efficiency, may end up being considered unfair.31 For example, according to Levine (1981), airline deregulation in the United States was to a large extent a reaction to the various inefficiencies introduced and propagated by the CAB’s attempts to regulate “fairly.”32 In this regard, it should be 29 P. Oleson, 2001, An experimental examination of alternative theories of distributive justice and economic fairness, Ph.D dissertation, Department of Economics, University of Arizona, Tucson. 30 E. Schlicht, 1998, On Custom in the Economy, Clarendon Press, Oxford, U.K., p. 131. 31 E.E. Zajac, 1998, The Telecommunications Act of 1996: A policy analysis test bed, in Telecommunications Transformation: Technology, Strategy and Policy, E. Bohlin and S. Levin, eds., IOS Press, Amsterdam, p. 301. 32 M. Levine, 1981, Revisionism revised? Airline deregulation and the public interest, Law and Contemporary Problems, v. 44, p. 179-195.
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remembered that the free market inherently promotes economic efficiency and, moreover, tends to be less plagued by fairness fights. Thus, the emphasis in the NRC’s Resolving Conflicts report on marketizing public activities is well placed. We in fact saw this with the FCC’s decision to auction off the spectrum allocated to digital cellular service.
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Representative terms from entire chapter: