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The Changing Nature of Telecommunications/Information Infrastructure (1995)

Chapter: PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE

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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Part 2
Regulation and the Emerging Telecommunications Infrastructure

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Introduction to Part 2

Roger G. Noll

National policy regarding the information infrastructure is often debated as if it were a novel idea; however, the current debate is in many ways old wine in new bottles. The backbone of the information sector of the economy—the telecommunications network—has been regulated by both national and state governments since the Bell system first perfected reasonably high quality long-distance interconnection in the first decade of the 20th century. From the beginning, at the center of the policy debate has been the importance of nationwide interexchange traffic to the welfare of consumers and the long-term economic growth of the nation. Thus, any attempt to implement a dramatic new initiative regarding the national telecommunications infrastructure must deal explicitly with the presence of an elaborate regulatory superstructure that, despite two decades of liberalization, still extensively controls the decisions of the most important players in the telecommunications industry regarding prices, investment, technology, and system integration. And, in the mid-1990s, many of the policy proposals for encouraging enhancements to the telecommunications infrastructure amount to recommended changes in regulatory rules and processes.

The purpose of the papers in this section is to examine the role of regulatory policy in shaping the evolution of the nation's information infrastructure, with special attention being given to how regulation affects the rate and pattern of technological change. In both public discourse and the scholarly literature in law, economics, and political science, the debate about the merits of regulatory policy deals with two quite separate and distinct issues. The first is philosophical and deals with the legitimate uses of the coercive power of government. The second is more prosaically practical and deals with the actual effect of regulation on the performance of industry. Although this section deals primarily with the latter, we must first briefly deal with the former in order to clarify the range of issues of concern.

REGULATION AND POLITICAL LEGITIMACY

The first focus of debate about the merits of regulation concerns the enduring philosophical question about the legitimate boundaries to the use of the coercive powers of government. Regulation makes rules about how people can spend their incomes, use their wealth, and engage in transactions, and so infringes upon private property rights. From this fact has emerged a debate concerning whether regulatory policy goes too far, or not far enough, in making a trade-off between individual liberty and collective welfare. Thus, this form of the debate about regulatory policy deals with the principles that should be adopted through a nation's constitutional and legal system to define the proper role of the state in economic affairs.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

An important feature of this debate is that the instrumental value of regulation—its effects on the performance of regulated industries—plays a minor role. Causing the trains to run on time is not regarded as a compelling defense of fascism, for example, nor is the production efficiency of antebellum southern agriculture regarded as a serious argument against the Emancipation Proclamation.

More importantly, this form of the debate about regulation is most likely incapable of resolution regarding such prosaic issues as how, or even whether, government should attempt to control the development of infrastructural industries. Whereas the philosophical debate about the proper scope of state interference with private property rights does provide a compelling case against the more outrageous forms of authoritarian government, it does not contribute much to the debate in advanced western democracies about the appropriate methods for making and implementing economic policy. Among advanced western countries, for example, although no nation leaves the sector totally unregulated or has nationalized every aspect of it, national telecommunications policy does vary from near laissez-faire (New Zealand, United Kingdom) to an extensive nationalized enterprise (France, Italy). One cannot convincingly argue that any of these nations have organized telecommunications policy in a morally indefensible way. Hence, because the philosophical debate about the proper scope of government is, and is likely to remain, unresolved among the range of policies that are likely to be considered in a modern western democracy, this aspect of the debate about regulation is largely irrelevant and forms no part of the analysis in the remainder of this section.

INSTRUMENTAL ANALYSIS OF REGULATION

The papers that follow examine the second focus of debate over regulatory policy, which is concerned with the instrumental value of regulation.1 At the most general level, the instrumental issue is how the presence of government supervision of an industry, regardless of the details, affects its performance. The existence of regulation redirects the time of a firm's management from ordinary business activities, such as production supervision, technological innovation, and customer relations, to dealing with and strategizing about political affairs and the regulatory process. An inherent feature of regulation is that, no matter how enlightened, it creates costs and affects the rate and pattern of technological change in an industry.

Some specific instrumental issues are how the performance of the regulated industry depends on the details of regulatory policy, such as the decisions about who will be regulated, what powers will be given to the regulators, how the regulatory authority will be organized and what procedures it will be required to follow, which level of government will be responsible for each element of regulatory policy, and what role will be assigned to the courts in overseeing regulatory policy. In the case of telecommunications, examples of specific issues that have been especially prominent in recent years are the debates about the jurisdictional separation of regulation of prices and entry between the Federal Communications Commission (FCC) and state public utilities regulators, the continuing judicial intervention in structuring the market for telecommunications services and equipment arising from antitrust litigation, and methods for regulating prices by a monopolist (e.g., rate of return, price caps, residual pricing, and so on).

The instrumental issues about regulation can be phrased in either a negative or a positive way. The negative version inquires about the extent to which regulatory policies and institutions distort the evolution of the telecommunications infrastructure, to the detriment of the welfare of society. The positive version seeks to identify ways that regulatory policy should be changed to improve the performance of a regulated industry. Of course, the way in which the question is put is primarily a rhetorical device, revealing more about the conclusion of the person addressing the issue than the actual nature of the debate. Regardless of how the issue is phrased, the core of the relevant

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

policy debate is the following question: What will be the effect of different approaches to regulatory policy on the performance of regulated industry?

SOME GENERAL CAVEATS

By way of introduction to the papers that follow, the current debate about the national information infrastructure should be considered in the context of over a century of U.S. experience with regulatory policy in a variety of infrastructural industries. Economic regulation in the United States takes a peculiar form that is not found anywhere else in the world. It evolved as it did because of certain unique features of the U.S. political and legal system: the federalist system of government, the separation of powers among the three branches of government, the unusually strong role of the courts in the American system, and the specificity of certain rights in the U.S. Constitution, such as the guarantee of the sanctity of contracts, the protection against expropriation of property without compensation and due process of law, and the guarantees of free speech and freedom of the press. These special features of the U.S. system thwarted numerous attempts to establish economic regulation during the 19th century and continue to affect how regulation is implemented today.

The first important consequence of the U.S. system of government is that it makes policymaking very difficult. A significant change in policy requires a statutory mandate, and statutes are very difficult to enact. Both houses of Congress and, in the absence of a two-thirds majority in either, the President, elected on the basis of different principles of representation, must agree before a statute can be passed. And, if someone then protests the new statute, the Supreme Court can declare it invalid—a power that was controversial at the time it was asserted by the court early in the 19th century, and that is shared by almost no other high court anywhere in the world.

The second important consequence of the U.S. Constitution is the elaboration of economic protection accorded citizens in the Constitution, as enforced and interpreted by an especially powerful court. Numerous statutes, mostly enacted by states, have been overturned by the Supreme Court because they were judged to interfere with one or another constitutional provision. Judicial skepticism of regulatory interference with the private economy persisted into the early years of the New Deal, when, under the threat of increasing the size of the Supreme Court to accommodate a more interventionist political philosophy, the "switch in time to save nine" finally permitted extensive interventionist policies. But even the post-New Deal courts placed important constraints on economic regulation. These constraints have been derived from both constitutional principles of economic rights and the details of statutes that elaborate how the constitutional role of the courts and protection of individual rights should be embodied in the details of regulatory policymaking.

Constitutional and statutory requirements impose substantial burdens on regulators to prove that their decisions are justified. Regulators bear a legal burden to show that their decisions are based on a constitutionally valid statutory mandate, and an evidentiary burden to show that their decisions are rational means to pursue a statutory objective and take into account all of the relevant facts and arguments presented by those who might be affected by the decision. Again, the structure of the Constitution has the effect of making policy change slow and difficult, and subject to veto by the courts. Moreover, these requirements advantage large business interests with a major financial stake in regulatory outcomes, because they are more likely to provide detailed evidence in support of their interests than are consumers and other less well-organized user groups, and more likely to appeal adverse regulatory decision to the courts.2

The history of telecommunications regulation illustrates these points. The origins of telecommunications regulation can be traced to the middle of the 19th century and the battle to establish railroad regulation.3 Many states attempted to regulate railroads for the purpose of eliminating the "long-haul, short-haul" price differential in railroad prices. Typically, railroads

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

competed for long-haul traffic but were monopolists at intermediate rural terminals along their networks. Railroads exploited these local monopolies by charging far higher prices for shipments to and from these rural locations than for more competitive transportation between large urban centers. Except for a brief period between 1877 and 1886, the Supreme Court persistently declared as unconstitutional these attempts by states to deal with short-haul monopolies.

In 1887, after the 1886 Wabash decision in which the Court declared all state regulation of any aspect of an interstate railroad to be an unconstitutional interference with interstate commerce, the federal government enacted the Interstate Commerce Act (ICA). This statute had two important elements. The ICA established federal regulation of railroads, and it gave states the authority to regulate railroad tariffs for shipments between terminals in the same state.

Two decades later, the scope of the ICA was expanded to include telecommunications.4 The Mann-Elkins Act of 1910 enabled the Interstate Commerce Commission (ICC) to regulate the interstate portion of telecommunications; however, this business was then so inconsequential that the ICC ignored its new responsibility. The important effect of this extension of the statute was that it legalized state regulation of intrastate telecommunications. Then, in 1934, the Communications Act created a new institution to regulate the interstate portion of the industry, the Federal Communications Commission. But most of the telecommunications sections of the 1934 act were transferred wholesale from the ICA, despite many failed attempts within Congress to alter these provisions to match the differences in the technologies and market structures between railroads and telephones.5

In the ensuing decades, Congress has made numerous attempts to rewrite the Communications Act to reflect the realities of new technologies and changing market structures in the industry. Except for a handful of exceptions (laws dealing with satellites, cable television, and radio telephony), these attempts have failed. In 1994, Congress again failed to pass a reform bill (S. 1822, sponsored by Senator Ernest F. Hollings) that died in the Senate after passing overwhelmingly in the House. Consequently, the 1934 statute remains the basis for almost all telecommunications regulation today, including the scope and methods of regulation by the FCC and separation of authority between the FCC and the states. Thus, as the United States attempts to make policy about the information infrastructure of the 21st century, it does so in the context of a regulatory statute that was written in the 19th century to deal with local railroad monopolies.

The significance of the U.S. courts is clearly evident in telecommunications regulatory policy. Most of the important changes in telecommunications regulation since the passage of the Communications Act of 1934 are the result of court decisions, rather than new statutes or policies adopted by the FCC. Examples are the Execunet6 decisions, which led to competition in ordinary long-distance telephone service, the restructuring of the industry in the settlement of U.S. v. AT&T,7 and the Louisiana8 decision, reversing 50 years of precedent to give more regulatory authority to the states over aspects of the local exchange that have a significant effect on interstate elements of the industry.

The preceding history is crucial to understanding why the academic literature is so skeptical about the value of economic regulation, both in general and with respect to telecommunications. As an instrument of public policy, regulation—at least in the U.S. system of government—has inherent properties that limit its effectiveness. Regulation is intrinsically slow, and changing regulatory policy is extremely difficult. The U.S. system of government exalts the status of individuals and private property like no other, and so imposing costly rules on anyone is difficult. In the United States, policies are developed and changed by an elaborate process that is designed to protect individuals against significant, targeted economic harm by government, and to allow change only when a broad consensus supports it. Thus, regulation is especially problematic as an institution for channeling the development of an industry in which technology is evolving rapidly and involves an ever-changing cast of companies and user groups.9

The fact that the "information superhighway" of the 21st century is being constructed under the aegis of a 19th-century statute for regulating railroads is not the result of stupidity, corruption, or

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

inattentiveness on the part of government, but a highly significant example of a fundamental feature of U.S. governance. The United States operates under a system that is based on a deep skepticism of government intervention in economic affairs and that makes rational national planning of industrial development extremely difficult.

It is important to note that making industrial policy difficult and cumbersome, and hence less extensive, is not necessarily bad. To illustrate the point, consider the differences in the performance of the telecommunications sector in Japan and the United States10 In Japan, judicial supervision and authority over economic policy are far less extensive, and legislative and executive functions are not formally separated. As a result, the legislature can more easily change policies by statute, and the implementing bureaucracy is less constrained about the scope of its decisions.

In 1986, the Japanese passed new laws that in many ways are very similar to the combination of court decisions and regulatory policies that took place in the United States in the previous two decades. By statute the Japanese created a structurally competitive telecommunications industry, but they retained their traditional system of ubiquitous government control over prices, investment, and entry into facilities-based telecommunications services. As a result, the number of facilities-based domestic telecommunications companies grew from 1 to 38 in 6 years, counting all satellite, wire, and over-the-air carriers.

Because the core economic decisions of the industry continued to be controlled by the government, the new structural competition did not lead to real economic competition. The new entrants were permitted to charge much lower prices for dedicated circuits, which are typically purchased by very large, multifacility businesses; however, in other aspects of the industry companies were prohibited from competing on the basis of either price or the quality of service. The objectives of this policy were in part to allow more companies to participate in the lucrative telecommunications services business, and in part, like U.S. policy objectives, to encourage more rapid development of a ubiquitous, integrated, high-performance telecommunications infrastructure.

By the criteria most Americans would use to evaluate the success of the Japanese policy change, the outcomes are not attractive. In 1992, a Japanese customer of telephone service paid about $560 for the installation of new telephone service, which is about 10 times the price charged for initial residential installations in the United States. Consequently, the number of telephones per capita in Japan is about 20 percent lower in Japan than in the United States. Thus, the more extensively regulated, less competitive system does a significantly worse job of achieving universal service.

After paying $560, a Japanese residential subscriber paid about $20 a month for basic access service in 1992, but this service does not include any calling. In addition, a Japanese consumer paid 8 cents for each 3-minute interval of a local telephone call, a charge that has since risen to 15 cents. In addition, the Japanese consumer faces significantly higher prices for long-distance calls, especially for calls at distances over 100 miles. As a result of this pricing system, the Japanese use their telephone system much less intensively than do Americans. Minutes of use per line per year in Japan are about one-sixth the amount of usage in the United States. The Japanese place many fewer telephone calls and have much lower average connect time than is the case in the United States.

Higher prices, lower penetration, and less usage in Japan obviously result in lower consumer welfare; however, the problems with Japanese telecommunications policy go beyond these effects. If an important social objective is to facilitate the introduction of new telecommunications services, the Japanese policy thwarts them. New services require more calls and connect time, and their ubiquitous availability requires universal service. The Japanese system accommodates neither, and so serves to retard the evolution of the Japanese information infrastructure in comparison to that in the United States.

Japan differs from the United States in many respects other than the legal and institutional structure of industrial policy, and so broad conclusions drawn from these facts need to be strongly qualified. Nevertheless, a slow-moving but limited regulatory system, coupled with greater reliance

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

on competition, actually produces relatively good performance in comparison with the systems in other advanced, industrialized nations.

IMPLICATIONS FOR EVALUATING REGULATORY STRATEGIES

Of course, the preceding observations do not fully resolve the debate about regulation. Regardless of the problems associated with regulation, both citizens and government officials will seek to interfere with private economic decisions if they believe that these decisions do not adequately take into account important collective values. Although regulation has inherent features that limit its effectiveness, these effects are only one part of a larger concern. Inherently imperfect regulation can be better than nothing when dealing with a firmly entrenched monopoly or an economic activity that imposes significant social costs, such as creating pollution.

This introduction is intended to make a simple point that is often overlooked in the debate about regulatory policy: citing a meritorious policy objective is not sufficient to justify the conclusion that regulation is warranted. Moreover, even a strong case for a serious market failure leaves another important issue unaddressed: how to design the details of regulation to ameliorate to the maximum feasible extent the inherent infirmities of the regulatory process. Questions about how best to divide jurisdiction between federal and state authorities, or between regulators and the courts, and about what principles to adopt in controlling prices and service attributes, must be answered in part on the basis of their feasibility in the U.S. legal and political system. Because the process of policymaking is important in the American system, the instrumental value of regulatory policies is often strongly influenced by the details of its implementation.

An important illustration of these points is the ongoing debate about cable television regulation. In 1992, Congress enacted a statute, over presidential veto, to reregulate cable television. A veto-proof two-thirds majority was obtained by constructing an elaborate statute, carefully defining what could and could not be regulated, how regulation was to be implemented, and who was to implement each aspect of regulation among the FCC, states, and local government. A year later, the FCC implemented the statute by issuing detailed pricing rules and a process for certifying local regulation.

On the basis of initial studies, the effects of this elaborate process appear to have been minimal. Some prices went up, others went down, but on average the changes were small. Most local governments have decided not to attempt to become certified regulators, regarding the cost as not worth the candle. The main observable effect has been a reshuffling of the channel numbers assigned to various programmers, a step necessary for most cable systems to minimize the effect of the new rules on their total revenues from subscribers.

At the heart of the new cable regulations was an important economic fact: cable television systems are enormously profitable, selling for several times their construction costs, because typically they have considerable monopoly power. But the question posed by the history of the construction and implementation of the 1992 statute is whether any cable regulatory system that is politically feasible and constitutionally valid can yield benefits that exceed its costs. Thus far, the preliminary results indicate that the answer is no, even though cable does enjoy revenues that substantially exceed the economic costs of service.

The problem with cable regulation is not the validity of the objective, but the thus-far unsolved problem of implementing a regulatory system that can make significant progress in achieving that objective. Of course, the cable lesson does not translate directly to telecommunications. Cable is a far less important industry than telecommunications, at least for now. Unlike telecommunications, cable is not an important factor determining the performance of many other rapidly growing, high-technology industries, and for consumers cable does not yet offer the highly valued, almost indispensable services that are accessible only through the telephone. Thus,

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

the prospective benefits of telecommunications regulation are larger and would justify considerable inefficiency in an imperfect regulatory system.

Nevertheless, the cable debate makes clear the preference for competition rather than regulation that is expressed by numerous observers of the communications industry. The experience with cable adds weight to the argument that easing the entry of direct broadcast satellites, of off-air digital distribution systems, and even of second cable companies or telephone companies into the cable business will do a better job than regulation in holding down cable prices and expanding service offerings to consumers. Likewise, the cable experience raises important questions about whether the promotion of competition, perhaps accompanied by some direct, targeted subsidies for particular users, will do a better job than regulation of encouraging the development of the information superhighway of the 21st century.

Congress, the FCC, the Justice Department's Antitrust Division, and the courts have before them numerous proposals to restructure telecommunications regulation. The failed Hollings bill combined with alternative proposals from Republican Senate leader Robert Dole will continue to be live legislative issues in the next session of Congress. Two competing visions of the future are embodied in these legislative proposals. One (Hollings) formalizes the importance of competition policy by placing a burden of proof on Bell operating companies for having their line-of-business restrictions removed, reestablishes the preLouisiana preemption authority of the FCC, and legislates a broad universal service requirement that, among other things, requires all telecommunications carriers to subsidize service to various educational and nonprofit institutions. The other (Dole) imagines a smaller role for federal intervention, eliminating the line-of-business restrictions without further requirements, and all but deregulating interstate service and interconnection among carriers.11 Nevertheless, these two bills share two important policies. First, both proposals would establish a tax on all telecommunications services for the purpose of subsidizing local exchange service in smaller communities. Second, both would eliminate restrictions against entry into local exchange service, including prohibitions against entry by cable television and other utility companies. (In Japan, electric utilities have been an important source of entry into facilities-based telecommunications services.)

Meanwhile, significant restructuring proposals have been submitted to the Antitrust Division, the FCC, and the D.C. District Court that oversees the divestiture decree. These proposals involve the movement of local exchange carriers into long distance and manufacturing, and of long-distance carriers into local access.

In the summer of 1994, the Antitrust Division allowed AT&T back into the local access business by allowing the merger of AT&T and McCaw Cellular, the nation's largest radio telephone company, after insisting that McCaw provide equal access to all long-distance carriers and that AT&T continue to supply cellular system equipment to McCaw's competitors on a nondiscriminatory basis. Later in the fall, implementing 1992 legislation that will eventually allow a competitive radio telephone industry, the FCC auctioned new spectrum for radio telephone services, which is expected to lead to the entry of several new access providers in all major metropolitan areas.

Facing some access competition already in the downtown areas of large cities, and much more potential competition from radio telephony and, conceivably, cable television, some local exchange carriers have proposed deals that would allow them to enter manufacturing and long distance, both of which would increase the chance that they could be more effective competitors in markets for information services. The most imaginative of these proposals comes from Ameritech, the regional Bell operating company in the Great Lakes region. Ameritech proposes complete unbundling of the elements of local service and relaxing all regulatory barriers to the entry of competitive access providers in return for eliminating its line-of-business restrictions. Unbundling, accompanied with realistic, cost-based prices, would enable competitors to enter the local access market by leasing and reselling elements of the Ameritech network in combination with their own

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

facilities. For example, MCI might lease copper wire connections between households and the local central office, but at that point branch the connections to its own local switch rather than use Ameritech's switch, and might provide metropolitan interexchange service by building some of its own trunks between switches, but leasing some trunk capacity from Ameritech.

All of these proposals share a new vision of local access: because of encouraging prospects for radio telephony, independent local networks (most private, but a few public), cable television, other utility companies, and extension of the reach of long-distance carriers, local access ought not to be a protected monopoly, and may some day be reasonably competitive—and, perhaps, even unregulated. Disagreements arise about exactly when each type of company should be permitted into which markets and under what conditions, and about how to define, and to pay for, universal service. But the present reality is that more than half of investments in telecommunications networks are now being made for local systems other than the traditional monopoly local exchange network, and the political system, at least at the federal level, has pretty much reached accord that this diversity should be facilitated rather than retarded.

VARYING VIEWS ON REGULATION

The papers that follow provide a range of views about these developments, the prospects for competition in all elements of the industry, and the ways that federal and state regulators are responding to them. Robert Crandall summarizes the objectives and performance of telecommunications regulation. He points out that the objectives of regulation are more complex than simply protecting consumers against monopoly, and in particular that the objective of fairness—all citizens should have access to approximately the same range of services at roughly the same prices—conflicts with giving service providers proper incentives for operating efficiently and adopting warranted new technologies. Because of this conflict, regulation often is the primary barrier to competitive entry, made so because regulators fear that entry will upset the fairness of the system. Crandall explains that this sacrifice of efficiency for fairness is becoming increasingly costly as telecommunications technology progresses, and he advocates regulatory reforms that minimize the scope of regulation and, where regulation is necessary because of market power, that accord greater weight to economic efficiency.

Robert Harris picks up Crandall's themes about the growing importance of an efficient telecommunications system and the desirability of less extensive regulation. According to Harris, telecommunications must be seen as part of an overall strategy for economic growth, much as railroads were a primary engine of economic development in the 19th century. The rationale for government intervention is gradually shifting from protecting consumers against monopoly to assuring complete interconnection, including among competitive carriers. The latter concern arises because the network is more valuable to each user as the number of accessible people and businesses increases. Harris concludes with a survey of regulatory reform activities in several states that appear to be placing a greater emphasis on efficiency, and in some cases to be proactively procompetitive.

Dale Hatfield addresses the issue of competition between local telephone and cable television companies. Because of fundamental structural differences in the nature of these two local networks, Hatfield concludes that neither is likely to become an important competitor to the other in the next few years. Hatfield expresses concern that the movement by Bell operating companies into video services will be expensive and will be driven more by the distorting effects of regulation than by any efficiency or procompetitive advantage flowing from such entry.

Nina Cornell focuses on the precise nature of the bottleneck monopoly enjoyed by local access providers. Cornell's main theme is that as long as local exchange carriers have control over termination, they will have market power over the entire network. And, according to Cornell,

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

historical experience teaches that control over termination has inevitably led to actions to extend the monopoly to other elements of the industry. Thus, for a procompetitive, free-entry regime to work, policy must succeed in making both originating and terminating access competitive. To do so will require unbundling of termination and efficient pricing of the unbundled elements. Moreover, the pricing regime will require more than price-cap regulation, since price caps do not prevent, and sometimes reward, strategic pricing to harm competitors.

Thomas Long expresses the common concerns of consumer advocates about the diversification of telephone companies and the adoption of efficient pricing systems for local access. The essence of Long's concern is that network upgrades for the few or that may not be efficient for anyone will lead to higher prices for all consumers. Reliance on access competition to prevent this outcome is, in Long's view, unrealistic, and regulators seem prone to believing that there is more competition than in fact exists. Long believes that allocating some of the fixed costs of the local network to services other than basic access is the best safeguard against consumers becoming involuntary investors in high-technology services that they do not want or need.

Bridger Mitchell's paper clarifies the economics of local telephone networks, and in particular the concepts of subsidy that are relevant for policymakers. Cross-subsidy occurs when, given current prices, other customers and the network supplier would be better off if a service were abandoned. Basically, this means that a service is not being subsidized if its price exceed the incremental cost of service. Mitchell than examines the cost structure of California local access companies to ascertain exactly who is and is not subsidized. Mitchell's work indicates that:

  • Flat-rate residential service is probably economically efficient (the gains from measured rates are more than offset by the measuring and billing costs);

  • Because local access costs are driven primarily by the distance of customers to the local switch, state-wide rate averaging subsidizes customers in sparsely populated areas and discourages the efficient adoption of radio telephony rather than wirelines as the means of providing access in rural areas; and

  • The incremental cost of service is less than half of the average cost, indicating that in most areas wireline access is a natural monopoly and that most residential subscribers are not being subsidized.

Eli Noam provides a conceptual framework for understanding how regulatory issues evolve over the life of a communications network. Initially, because of economies of scale and the fact that each consumer values the network more highly as it acquires more customers (the ''network externality"), the primary issue is promoting the growth of the system. This phenomenon applied to basic access for the early history of telephony, and applies today to new capabilities such as Internet and, perhaps, digital transmission. Once these scale and externality factors become less important, the primary policy issues shifts—to promoting competition and mandatory interconnection where warranted, but to protecting "cream-skimming" entry driven not by efficiency but by price distortions arising from the "fairness" objective. Finally, in the late stage of a system, costs are rising and further expansion of the system is not worthwhile, and policy focuses more on encouraging migration to another, usually more advanced system and making certain that those with investments in the old system do not succeed in artificially maintaining its dominance by erecting barriers to entry—including regulatory, legal, and political barriers.

Collectively, the papers in this section reflect the dilemma of regulatory policy as technology and market structure rapidly evolve in the telecommunications industry. The core economic uncertainty is how important the new technologies will be, whether that importance is limited to a minority of sophisticated customers or a large fraction of the businesses and residences in the

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
×

nation, and the extent of natural monopoly that will be present in each major component of the network during the next decade or two as the use of these new technologies spreads. The political problem flowing from this economic uncertainty is the relative importance of the two major duties of regulatory policy: protecting consumers against a ubiquitous, impregnable monopoly and assuring universal access to prosaic telephone service, or facilitating the rapid adoption of advanced new technologies. For the most part, conflicts over the proper nature and scope of regulation, including whether extensive deregulation is in order, arise from continuing disagreement about the technological and economic future. But in setting a future course, policymakers need to take into account that a regulation-intensive process tends to equalize prices and access across groups, but in the process tends to slow change, inhibit the entry of new firms with new ideas, and advantage status quo players.

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Capron, William. 1971. Technological Change in Regulated Industries. Brookings Institution, Washington, D.C.

Cass, Ronald A. 1989. "Review, Enforcement, and Power under the Communications Act of 1934," A Legislative History of the Communications Act of 1934, Max D. Paglin, ed. Oxford University Press, Oxford.


Joskow, Paul L., and Nancy L. Rose. 1989. "The Effects of Economic Regulation," pp. 1449–1506 in Handbook of Industrial Organization, Richard Schmalensee and Robert Willig, eds. North-Holland, Amsterdam.


Kanazawa, Mark T., and Roger G. Noll. 1994. "The Origins of State Railroad Regulation," pp. 13–54 in The Regulated Economy, Claudia Goldin and Gary D. Libecap, eds. University of Chicago Press, Chicago, Ill.


Noll, Roger G. 1989. "Economic Perspectives on the Politics of Regulation," pp. 1253–1287 in Handbook of Industrial Organization, Richard Schmalensee and Robert Willig, eds. North-Holland, Amsterdam.

Noll, Roger G., and Frances M. Rosenbluth. 1995. "Telecommunications Policy: Structure, Process, Outcomes," Structure and Policy in Japan and the United States, Peter Cowhey and Mathew D. McCubbins, eds. Cambridge University Press, New York, forthcoming.


Poole, Keith T., and Howard Rosenthal. 1994. "Congress and Railroad Regulation: 1874–1887," pp. 81–120 in The Regulated Economy, Claudia Goldin and Gary D. Libecap, eds. University of Chicago Press, Chicago, Ill.


Robinson, Glen O. 1989. "The Federal Communications Act: An Essay on Origins and Regulatory Purpose," A Legislative History of the Communications Act of 1934, Max D. Paglin, ed. Oxford University Press, Oxford.


Thierer, Alan D. 1994. "Senator Dole's Welcome Proposal for Telecommunication Freedom," Heritage Foundation Backgrounder, No. 233 (August 24).

NOTES

1.  

For an excellent summary of the research literature on the effects of regulation on economic performance, see Joskow and Rose (1989).

2.  

For a survey of the research that explores how politics and political institutions shape regulatory policy, see Noll (1989).

3.  

For more about the origins of railroad regulation, see Kanazawa and Noll (1994) and Poole and Rosenthal (1994).

4.  

For a good history of the early telecommunications industry and its regulation, see Brock (1981).

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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5.  

For details about the close statutory relationship between the Interstate Commerce Act and the Communications Act of 1934, see Cass (1989) and Robinson (1989).

6.  

MCI v. FCC, 561 F,2d 365 (D.C. Circuit 1977) and 580 F.2d 590 (D.C. Circuit 1978).

7.  

The preliminary ruling by Judge Harold Green rejecting summary judgment and indicating a likely victory for the government: U.S.v. AT&T, 552 F. Supp, 131 (District Court for D.C. 1982); the final judgment divesting the company (entered as a modification of the settlement of the earlier case): U.S. v. Western Electric, 569 F. Supp. 990 (District Court for D.C. 1983).

8.  

Louisiana Public Service Commission v. FCC, 476 US 355 (1986), held that the FCC could not assert jurisdiction over intrastate regulation simply because the latter affected the FCC's interstate policies if it was technically possible to divide jurisdictional authority. This decision explicitly reversed the previous judicial interpretations of FCC authority, which held that the FCC could assert jurisdiction if a service was not wholly intrastate in character, as most clearly articulated in North Carolina Utility Commission v. FCC. 537 F.2d 787 (4th Circuit 1976). The reach and durability of the Louisiana decision remain disputed and controversial, but the decision has certainly generated considerable inconsistency in the jurisdictional separations between state and federal authorities. For example, the FCC was allowed to assert jurisdiction over telephone instruments for the purpose of unbundling and deregulating them (see North Carolina and Computer and Communications Industry Association v. FCC, 693 F.2d 198 (D.C. Circuit 1982)), but when it attempted to do the same thing for inside wire it was allowed to require unbundling but not to require deregulation (NARUC v. FCC. 880 F.2d 422 (D.C. Circuit 1989)).

9.  

For an excellent compendium of how regulation altered the rate and direction of technological progress in infrastructural industries during the 1950s and 1960s, see Capron (1971).

10.  

For more details about the comparison between Japan and the United States, see Noll and Rosenbluth (1995).

11.  

For a descriptively accurate if somewhat partisan analysis of the two basic approaches, see Thierer (1994).

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Government Regulation and Infrastructure Development

Robert W. Crandall

The 1970s and 1980s provided students of regulation with a wealth of empirical evidence on the effects of regulation and deregulation on prices, output, and service quality in many industries. This evidence has confirmed much of the prior research that concluded that regulation reduced economic welfare. Indeed, Winston's recent comprehensive survey of the field suggests that, if anything, economists underestimated the benefits of deregulation, in large part because they failed to predict the development of new services and technology after deregulation (Winston, 1993).

It has been 34 years since the Federal Communications Commission (FCC) began to liberalize the telecommunications sector by allowing private microwave service; 24 years since the FCC allowed entry into private-line long-distance service; 19 years since MCI entered switched long-distance service despite the FCC; and 11 years since AT&T agreed to a divestiture to settle a 1974 antitrust suit. Communications technology has improved at an explosive rate over this period, and there appears to be no slowing of this progress on the horizon. Despite all of these changes, telecommunications remains a highly regulated industry—regulation that is still justified by concerns over natural monopoly.

If, as Winston found, economists were unable to predict how the airlines would build their networks after deregulation with a fleet of jets whose technology has changed very little since the 1978 deregulation, economists should certainly be wary of pretending to know how the nation's communications infrastructure will develop with or without the heavy hand of government regulation and/or subsidy. While some students of telecommunications technology—many of whom are potentially heavy users of new network infrastructure—may have strong views about how they would like to see the nation's communications infrastructure develop, their vision may not be consistent with the developments that maximize economic welfare.

It is my view that regulation should not be seen as a form of government infrastructure planning, but rather as a source of restraint on actors who enjoy some modicum of market power that should decline as the potential for monopoly diminishes. In this paper I attempt to outline the major regulatory issues that have arisen in telecommunications as some regulators have moved to liberalize market entry while still maintaining control over a variety of rates and other operating parameters of incumbent carriers. In so doing I shall focus as much as possible on the implications of these issues for infrastructure evolution. I start, however, with a brief digression on the definition of "infrastructure."

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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WHAT IS INFRASTRUCTURE?

To many participants in the debate over industrial policy, infrastructure is generally thought of as those facilities owned by government or by private, regulated utilities. By this definition, common-carrier telephone systems, common-carrier energy distribution systems, sewers, water utilities, government buildings, and public schools are infrastructure, but private computer networks, private schools, private roads, or shopping centers are not.

This distinction between public capital and private capital in unregulated firms may be useful for some purposes, but it is surely misleading in telecommunications. Billions of dollars have been invested in private networks that are at least related to if not part of our communications infrastructure even though they are not generally available to other users. Presumably, these facilities reflect the decisions by private concerns that total reliance on common-carrier facilities is not in their best interests. Indeed, it may be that the role of common carriage is rather limited in an efficient, dynamic market with rapidly changing technology and equally rapidly changing user requirements. It is even possible that the only communications infrastructure may eventually be a set of interfaces among myriad private networks.

Unfortunately, there may be no way for the student of telecommunications to determine which combinations of private and common-carriage network facilities reflect an optimal configuration. It is for this reason, among others, that public policy is moving toward more open access of unbundled common-carrier facilities, allowing a myriad of possible combinations of common-carrier and other facilities.

In the discussion that follows, I assume that the goal of public policy should be to allow a multitude of actors to invest in new technology and to develop the public/private network in a fashion consistent with their needs. This may result in a multitude of private networks that interconnect in some hierarchical fashion with or without the assistance of large common carriers, or it could lead to a number of competing large networks—owned by, say, AT&T, MCI, TCI, Time-Warner, Hughes, and the regional Bell operating companies.

WHERE IS THE NATURAL MONOPOLY?

The stated objectives of most telecommunications regulation is the protection of the public from the evils of monopoly power that might be exerted by telephone common carriers through raising rates above incremental costs and/or denying their actual or potential rivals access to their bottleneck facilities. In fact, the objectives of most regulators are much broader than this. Operating in a political arena, these regulators view regulation as an exercise in "fairness," protecting residences, small businesses, and rural Americans from having to pay the full (long-run incremental) cost of basic telephone service.1 As a result, it is widely accepted that other services "subsidize" basic local service for these groups of ratepayers.

Some may and will debate this conventional wisdom about widespread cross-subsidization in telephone regulation. However, one recent empirical study confirmed the existence of such cross-subsidies (Palmer, 1992) using Faulhaber's test for subsidization (Faulhaber, 1975). Many others have reached the same conclusion through more informal empirical tests (Perl, 1985; Crandall, 1991).

Even if cross-subsidies do not exist in the sense that rates do not lie outside the range between stand-alone costs and incremental costs, it seems clear that state regulators in particular have historically been quite reluctant to allow prices to move toward Ramsey (quasi-optimal) levels (Baumol and Bradford, 1970). Specifically, usage rates—particularly for toll calls—have been kept too high and access rates too low for most customers in response to apparent political demands.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Ironically, it has always been thought that the most likely locus of natural monopoly in telecommunications is in providing access to dispersed small customers. But there cannot be any test of the existence of such power as long as regulators deliberately keep the price of access artificially low to satisfy political objectives while frustrating entry into other markets from which the "subsidies" are paid.

Recent changes in technology have cast doubt on the notion that local access markets are natural monopolies. The development of new access technologies that employ the electromagnetic spectrum are threatening to provide ubiquitous competition for the traditional wire-based systems. Cellular competition is increasing as providers seek out new spectrum and employ new digital technology. Personal communications networks are only in their infancy, but they too may add substantially to consumers' choices for gaining access to the network.

On the other hand, fiber optics may have such large-scale economies as to threaten to reestablish AT&T's long distance monopoly (Huber et al., 1992).2 Now that there are three national long-distance networks and numerous other regional carriers, one might have expected interstate long distance services to be deregulated by the FCC. But fear of AT&T dominance and evidence that competition has not been responsible for lower rates (Taylor and Taylor, 1993) have made such deregulation difficult to complete. Fortunately, even if minimum efficient scale in fiber optics transmission is very large, transmission costs may be such a small share of total long-distance service costs that such economies alone could not reestablish AT&T's monopoly.

All of the current discussions about the locus of natural monopoly in telecommunications avoid a central fact: the potential monopoly power that exists today is as much a reflection of regulatory barriers to entry as to technology and market conditions. We simply do not know whether such power would persist in the absence of regulation because we have no market experiment to instruct and guide us. Moreover, given the incredible rate of technical change in this sector, we have no reason to believe that assertions based on today's array of telephone poles, paired wires, cables, and switches are very informative. Somehow, we need a market test of the effectiveness of competition in this sector.

THE REQUISITES OF PUBLIC POLICY

Given the rate of progress and the large number of actual and potential players in this sector, it is my view that regulatory policy should now stress:

  • Removal of the worst of the remaining rate distortions for access and usage;

  • Elimination of entry barriers into local, interexchange, and "information" services markets;

  • Deregulation of all but the "core monopoly" services and substitution of price regulation for rate-of-return regulation for these services; and

  • Regulatory forbearance from any attempt to guide network design or investment decisions.

Removal of Rate Distortions

There is no way that regulators can know the "true" costs of various telecommunications services given the pervasive joint and common costs in this sector and the rapid rate of technical change. Allocations of historical accounting costs are quite simply arbitrary exercises. Simulations of costs through forward-looking engineering models are equally subject to error and abuse by regulatory participants.

Nevertheless, it is fairly clear that toll usage rates are undoubtedly too high because regulated carrier access rates are kept above long-run incremental costs. Moreover, it is equally

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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clear that the incremental cost of a business loop is generally little different from the cost of a residential loop in the same geographical area and that the cost of access increases with the distance from the switch. Thus, a reduction in business access rates, an increase in residential rates—particularly in smaller communities—and a reduction in carrier access rates are generally required to move rates closer to incremental costs.

As rates are moved toward incremental cost, competition in providing local access to smaller customers will increase. At some point, cellular, personal communication networks (PCNs), or other technologies might actually begin to make local access a contestable market. Once this occurs, the degree of regulation of local exchange carriers (LECs) can be reduced, and LECs can be freed to compete in vertically related markets.

Removal of Entry Barriers

State regulators have historically been reluctant to admit competitors into local markets for fear of undermining the cross-subsidies they have crafted. Not only will elimination of cross-subsidies increase the probability of competition, but increasing competition will reduce the possibility for cross-subsidies.

Entry is taking place. State regulators are finding it increasingly difficult to prevent new fiber optics networks from developing in large cities, and they are largely powerless to stop the new entry that is occurring or is likely to occur in radio-based services.3 Cable companies are beginning to reconfigure their networks to compete in some fashion with the LECs. PCNs will begin to appear in a few years.

No one can foresee how the local access market will evolve. A few years ago it was widely believed that high-definition television would probably be an analog system. Until just recently, there was considerable doubt that telephone companies could deliver video services without extending fiber optics loops all the way to the subscriber. Given the rapid and unpredictable nature of technological change, regulators should allow relatively free entry and allow the market to determine the best arrangements for connecting residences and business to communications networks.

Of course, facilitating entry into access markets is not that simple. Entry is more likely if the new entrants can connect readily with incumbents, who, in turn, are obviously not eager to cooperate. Regulation of the terms of interconnection is thus inevitable, but on what terms? This leads to all of the problems of open network architecture, unbundling of basic service elements, collocation, and the provision of information on changes in the technical design of the core network. If regulators cannot know the incumbents' costs, how can they know the costs of the basic elements? I offer no magic solution to these problems.

Deregulation of Noncore Services

Among the most contentious issues in telecommunications policy is the development of safeguards to prevent a regulated carrier from cross-subsidizing competitive services from regulated monopoly profits. I do not intend to revisit the history of the FCC's approach to this problem in successive computer decisions, but the problem is pervasive and is likely to get worse.

As new technologies develop, the size of the monopoly "core" that requires regulation shrinks. Competition in intra-local access and transport area (LATA) toll, central-office services, or even local switching cannot be fully effective if the incumbent carrier is regulated and its rivals are not. Yet once the incumbent is allowed to compete freely in some markets while being regulated in upstream services, complaints of cross-subsidy and denial of comparable interconnection will

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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abound. The choice for regulators is either to require incumbents to shed services successively as they become competitive or to deal with the potential problems by shifting to price caps and enforcing rules of comparable interconnection. Neither "safeguard" is perfect, but the choice should be viewed as just one difficult step along the road to a competitive pluralistic network.

The substitution of price-cap regulation for the current cost-based approached favored by most state regulators will not only reduce the incentives for cross-subsidization by the regulated carriers but also will eliminate a powerful disincentive for technical progress. Cost-based regulation stunts the carriers' incentives to seek cost-saving or revenue-enhancing technologies, particularly when such regulation is accompanied by unrealistically slow depreciation schedules. Even though price caps are far from foolproof, any movement away from cost-based regulation should be eagerly supported by those who want to encourage major network investments by regulated carriers.

Forbearance from Mandating Network Technology

Historically, regulators have assumed a planning role in an attempt to prevent regulated carriers from padding the rate base under rate-of-return regulation. Investments are permitted if the new capital is "used and useful." In some instances, regulators have forced changes in technology to accommodate new services or new competitors, but they have generally stopped short of forcing regulated firms to push out the envelope of technology for fear that such investment will expose ratepayers to too much risk.

Some industry observers and users of advanced services now want to use regulation as a prod to investment in an advanced national information infrastructure or "superhighway." Regulated firms would be given assurances on rates for basic services in return for their commitment to build a high-speed switched network using fiber optics all the way to the subscriber or to the "pedestal." The precise configuration of such a network—whether it employs synchronous or asynchronous technology, for instance—is subject to considerable debate and uncertainty. Nor is it clear which services will be demanded by most subscribers or who will be allowed to provide them.

Given the speed of technological progress in this area, it is particularly dangerous to suggest that regulated firms, operating under a constitutional guarantee that they can recover their investment through subsequent rate increases, should be instructed by regulators to invest billions of dollars in new technology that may either prove unwanted or be surpassed by other technologies. Public utilities are not particularly good in making such decisions, as our recent sorry experience with nuclear power should confirm. Two years after being liberated from the Modified Final Judgment restrictions on information services, the Bell operating companies have not been very successful in developing and marketing new content-based services.

There is another important reason for not forcing (or subsidizing) investment by regulated carriers in advanced networks. Such a policy will only increase the pressure on regulators and legislators to limit competition since these massive new investments must be recovered through ratepayers or taxpayers. This will only increase the argument for protecting cable television companies, newspapers, and other information providers from the potential competition of regulated telephone companies. Rather than expanding the domain of regulated competition, we should be contracting it as rapidly as possible.

Given the bewildering array of technical possibilities for the "network of the future," it would be very dangerous for regulators (or legislators) to exclude competition from certain large players while mandating that telephone companies invest in what is perceived to be today's best choice for the network of the future. At this juncture, it is widely believed that residential demand for video services will drive the network design. But no one can be sure whether video on demand

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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(VOD) will completely replace today's multichannel offerings or just how it will be delivered. Will paired copper wires suffice for the last mile? Will coaxial cable systems be the best local loop for VOD? Can the current coaxial systems be modified to offer truly universal switched wide-band services, or will such services be offered best by telephone company asynchronous transfer mode (ATM) networks? One shudders at the thought of state regulatory commissions making these decisions.

CONCLUSION

Students of regulation have seen how it is the enemy of technical progress. Regulatory accounting, entry protection, and fears of cross-subsidies often prevent regulated firms and potential entrants from exploiting technological progress. The introduction of new freight cars, piggyback services, hub-spoke airline networks, multichannel urban coaxial cable systems, pay-television channels, and a myriad of telephone terminal equipment was delayed by regulators bent on protecting the public from the evils of monopoly restrictions of output. Given the extraordinary current rate of technical progress in communications, they should be reluctant to limit the domain of current players or of potential entry. Instead, regulators should look to open markets, constrict the core of regulated monopoly, and increase the number of participants in the communications sector.

Of course, a reliance on competition to develop network infrastructure will not please those who think they already know what a modern telecommunications network should look like. I would prefer this risk to repeating the mistakes made earlier in this century by regulating airlines, trucking, broadcasting, cable television, and telephony in the first place.

REFERENCES

Baumol, William J., and David F. Bradford. 1970. "Optimal Departures from Marginal Cost Pricing," American Economic Review 60(3):265–283.


Crandall, Robert W. 1991. After the Breakup: U.S. Telecommunications in a More Competitive Era. Brookings Institution, Washington, D.C.


Faulhaber, Gerald R. 1975. "Cross-subsidization: Pricing in Public Enterprises," American Economic Review 65(5):966–977.


Huber, Peter W., Michael K. Kellogg, and John Thorne. 1992. The Geodesic Network II: 1993 Report on Competition in the Telephone Industry. Geodesic Company, Washington, D.C.


Noll, Roger G. 1989. "Telecommunications Regulation in the 1990s," New Directions in Telecommunications Policy, Paul R. Newberg, ed. Duke University Press, Durham, N.C.


Palmer, Karen. 1992. "A Test for Cross Subsidies in Local Telephone Rates: Do Business Customers Subsidize Residential Customers?" The RAND Journal of Economics (Autumn):415–431.

Perl, Lewis. 1985. "Social Welfare and Distributional Consequences of Cost-based Telephone Pricing," paper presented at the Annual Telecommunications Policy Conference, Airlie, Virginia.


Taylor, William E., and Lester D. Taylor. 1993. "Postdivestiture Long-Distance Competition in the United States," American Economic Review: Papers and Proceedings 83(2):185–190.


Winston, Clifford. 1993. "Economic Deregulation: Days of Reckoning for Microeconomists," Journal of Economic Literature 31(3):1263–1289.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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NOTES

1.  

Roger Noll has called this approach to regulation "residual regulation." See Noll (1989).

2.  

Huber asserts that competition is now more likely in local access/exchange services than in long distance.

3.  

Nextel is already operating as a third cellular service.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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State Regulatory Policies and the Telecommunications/Information Infrastructure

Robert G. Harris

INTRODUCTION

Historically, the term "infrastructure" has been applied to public-sector investments in highways, airways, schools, and libraries. Because virtually all investment in the communications infrastructure was done by private business enterprises, there was a tendency to take it for granted. No longer. Historically, the United States has relied on a dual system of regulation, federal and state, that strictly limited competition and provided for a nearly guaranteed rate of return to private investors, to ensure the development of a ubiquitous public switched telephone network with affordable rates. It has become evident that the traditional regulatory policies for achieving and sustaining universal service are no longer viable. Because of dual jurisdiction, though, there has been a growing gap between procompetitive federal regulatory policies and those of many states, which are clinging to the regulatory regime of the past.

In this paper I briefly review some of the changes that have been and will be occurring in telecommunications technology, markets, and public policies. I explain the implications of these changes for the telecommunications/information infrastructure in the context of global competition and the strategic character of telecommunications and information services. I consider the implications of the changing character of telecommunications infrastructure for public policy objectives, emphasizing the need for public policies that place greater emphasis on dynamics than statistics, on the grounds that innovation and productivity improvements will generate more benefits than efforts to control prices or limit competition in hopes of maintaining historical cross-subsidies. I also briefly describe several recent state regulatory policy changes or pending initiatives that are consistent with the following progressive policy objectives: reducing rate distortions in the pricing of telecommunications services; reducing entry barriers in local exchange services; deregulating competitive or discretionary telecommunications services; and the adoption of price regulation, rather than rate-of-return regulation, of noncompetitive telecommunications services.

CHANGES IN THE TELECOMMUNICATIONS INDUSTRY

In the past decade or so the United States and other highly developed economies have entered the postindustrial era. In the industrial age the extraction of natural resources for energy and raw materials and the manufacturing of goods were the chief drivers of economic growth. While manufacturing continues to be important, employment in the service sector continues to grow, owing mainly to the tremendous advances in computers and communications. In the past century, agricultural employment has declined from 45 percent to less than 5 percent and employment in

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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manufacturing has returned to its 1890 level of 20 percent after peaking at 30 percent in 1960, while employment in services has exploded from 30 percent to over 77 percent (and 75 percent of the gross national product). Even in manufacturing industries, knowledge-based service activities (e.g., information processing, communications, research and development) constitute 65 to 75 percent of manufacturing costs and even more of the "value added" in the manufacturing sector (Quinn, 1992, pp. 3–30).

What railways, waterways, and highways were and are to the goods economy, telecommunications networks are to the service economy, since a very large share of value creation in the service sector involves the generation, manipulation, storage, retrieval, and other use of information. Today, information-based enhancements have become the main avenue to revitalize mature businesses and transform them into new ones. As chronicled by George Gilder in Microcosm, the basis of this transformation is microelectronics technologies and their application to computers, communications, manufacturing equipment, consumer products such as autos and household appliances, and virtually all service industries (Gilder, 1989, pp. 317–383).

As Davis and Davidson (1991) have pointed out, "Today, information-based enhancements have become the main avenue to revitalize mature businesses and transform them into new ones. In every economy, the core technology becomes the basis for revitalization and growth. Information technologies are the core for today's economy, and to survive all businesses must informationalize" (p. 17; emphasis in original).

To understand the role of telecommunications in that transformation, one must consider three major types of change in telecommunications—namely, changes in technology, markets, and public policies. In combination with the relatively faster growth of service industries, these changes have heightened the importance of telecommunications in economic development and, therefore, increased the value of developmental telecommunications policies (i.e., policies that promote, rather than inhibit, the development of a vital telecommunications sector).

After several decades of steady, but incremental, technological innovation and adoption in telecommunications, there has been a virtual explosion of new technologies in the past decade. Along with computers, telecommunications is on center stage of the microelectronics revolution: the application of transistors, semiconductors, integrated circuits and other microelectronics in telecommunications equipment has dramatically reduced equipment costs, improved the quality of service, and generated a host of new services and capabilities in the public switched telephone network (PSTN).

Through microelectronics the digitization of telephone switching has made possible many new services and reduced the costs of enhanced services. Digitization and optical technology in interexchange transmission, interoffice trunking, and cable TV distribution systems have reduced the costs of those services and created entry opportunities for cable companies and alternate access providers such as Metropolitan Fiber Systems. As federal policies and market competition have driven the prices of interexchange and data communications services toward costs, technological change has induced substantial increases in demand, thereby inducing investments in capital-embodied technological innovation.

At the same time, these developments have eroded the traditional natural monopoly character of the PSTN and stimulated the rapid market penetration of private branch exchanges, private telecommunications networks, facilities-based carriers, and resellers. Thus, local exchange carriers face competition from equipment suppliers (e.g., Centrex services competing with PBX vendors); with their own customers, who increasingly turn to self-supply of switching and network services; with competitive access providers for local exchange services; with established carriers like AT&T, MCI, and Sprint for switched and dedicated services; and with private pay phone vendors for public phone services.1

Contemporaneous with these changes in the wireline telephone network, technological developments in radio communications (including microwave), satellite (including direct broadcast

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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satellite to customers' premises), terrestrial broadcast radio and television, and cellular telephony have dramatically lowered the cost, improved the quality, and stimulated the proliferation of a wide range of wireless communications services. Not only has competition grown rapidly in each of these communications media, but as the capacity and range of services available through each medium have increased, so too has the competition among communications media. So, for example, sideband FM and TV broadcasting are now used to distribute financial market data and credit card verification information, in direct competition with the PSTN.2

There is every reason to believe that rapid technological change in both wireline and wireless telecommunications will continue, at accelerating rates, into the indefinite future. One major boost to innovation is the growing quest for technological advantage by leading competitor nations to the United States. Once the unrivaled leader in telecommunications equipment technology and system deployment, the United States faces competition from equipment manufacturers from Japan, Germany, France, and the United Kingdom, among others. Companies from these countries have committed major resources to telecommunications research and development and have caught up with U.S. suppliers in some technologies and passed them in others.3 This heightened international competition will almost certainly accelerate technological change, increasing the risk of economic obsolescence in the PSTN, but also expanding the potential benefits of investment in new technologies.

Dramatic changes are also occurring on both the supply side and the demand side of telecommunications markets. As little as ten years ago, local exchange carriers faced very limited competition for local network access. Today, traditional local telephone carriers face competition from a host of competitors and potential competitors: competitive access providers, interexchange carriers, cellular carriers, cable TV carriers, and, soon, personal communications services providers. Even small businesses and residential users have an increasing array of alternatives to PSTN services. For example, one can now use, in certain localities, (1) FM sideband for delivery of stocks and bonds price information to personal computers; (2) public TV sideband for delivery of credit card validation information to retail point-of-sale terminals; (3) a cable TV carrier for provision of local service bypass, local area networks, and metropolitan area networks; (4) cellular mobile as a substitute for coin-operated telephone service; and (5) a CD-ROM or magnetic disk database as a substitute for on-line access to information. More generally, there is growing competition between PSTN service providers and equipment vendors, including "SmartSets" (competing with "custom calling features"), auxiliary equipment such as answering machines (competing with voice mail), and personal computers.

Recent policy decisions by the Federal Communications Commission (FCC) to further open up local access to competition portend even more rapid change.4 The allocation of spectrum to facilitate the development of personal communications networks is one of the last nails in the coffin of the local exchange monopoly. Not surprisingly, other telecommunications companies are rushing to exploit new technological and regulatory opportunities in local exchange services. Recent announcements of the formation of strategic alliances among interexchange carriers, cellular carriers, and cable television carriers, such as AT&T's acquisition of a 33 percent interest in McCaw Cellular Communications (Karpinski, 1992a) and the Time Warner-MCI switched access trial in New York City (Karpinski, 1992b), will accelerate the emergence of vigorous competition for local exchange services.

The dramatic changes on the "supply side" of telecommunications markets have been matched by equally significant changes on the "demand" side. Rapid growth in the use of computers, data, and transactions processing systems (e.g., electronic funds transfers, credit card verification, automated teller machine networks, travel reservation services) has induced demand for data communications services, which is growing much faster than voice communications. With recent developments in computer graphics and image processing and storage systems, it is becoming evident that data will be superseded in the near future by images as the fastest-growing share of

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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communications traffic (e.g., American Express used to first keypunch data from credit card transactions, then move those data electronically from place to place; it now takes a "picture" of the credit receipt and moves the image from place to place). These changes from voice to data and image communications explain the need for and use of broadband transmission media.

As the demand for sophisticated telecommunications applications has grown, large business users have developed specialists in managing and purchasing telecommunications services. In just the past ten years, more than half of the Fortune 500 and thousands of medium and smaller enterprises have created a "chief information officer" position, to whom a range of computer, communications, and information experts and analysts report. With intimate knowledge of the technical and economic alternatives, these buyers continually seek out and exploit small differences in prices and have the capacity to assemble integrated systems from purchased "piece-parts." This means, in turn, that when regulated prices vary from market realities, buyers will turn to more economic alternatives.

Even among residential users, there are rapidly growing demands for advanced telecommunications and information services. With nearly 30 percent of the U.S. population engaged in work at home, and with more than 35 million personal computers in American homes, it is simply no longer true that residential customers will be satisfied with "plain old telephone service."

The divestiture of the Bell operating companies by AT&T and competition policy decisions by the FCC, in combination with the changes in telecommunications technology and market conditions, have facilitated competition in customer premises equipment, interexchange services, and, most recently, local exchange services. The FCC has consistently pursued procompetitive policies for the past decade, often in opposition to states, sometimes requiring the use of preemption over state regulations (e.g., customer premise equipment, inside wiring decisions). Clearly, the general direction of federal policy is procompetitive (NTIA, 1988).

ROLE OF THE TELECOMMUNICATIONS INFRASTRUCTURE

Some states have begun to liberalize their telecommunications regulatory policies since divestiture in recognition that traditional policies cannot cope with rapid changes in technology, competition, and market conditions. States such as Michigan, New Jersey, and Tennessee are explicitly using reformed telecommunications policies to promote state economic development, improve public services, expand educational and social services, and create a better economic environment to attract businesses and skilled jobs. As more and more states implement progressive, procompetitive policies in telecommunications, the cost of not keeping pace with these changes, in terms of lost jobs and economic development to other states, will increase.

These recent changes in state policies and perspectives reflect a growing awareness of the vital role of telecommunications in economic development. There is, in fact, a deep intellectual tradition that views telecommunications and other infrastructure industries in this way. In his seminal work, The Strategy of Economic Development, Albert O. Hirschman introduced the notion of backward and forward linkages from an infrastructure sector (e.g., energy, transportation, communications) to supplier and user industries (Hirschman, 1958). Hirschman explained why and how high investment in sectors with strong linkages will lead to more rapid economic growth. He coined the term "social overhead capital" to describe infrastructure industries that:

  • Provide services that are basic to a great variety of economic activities;

  • Exhibit a high degree of "publicness" (and are therefore usually provided by public agencies or private firms under public control);

  • Are immobile and therefore cannot be imported;

  • Have substantial "lumpiness" or technical indivisibilities; and

  • Have very high capital/output ratios, with large fixed investment required to achieve an economically viable level of output.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Given these characteristics, Hirschman argued that investment in social overhead capital not only was essential, but also required a national strategy for economic development. Hirschman's ideas provide the intellectual underpinning of national and state investments in railroads, waterways, highways, airports and air traffic control systems, hydroelectric projects, and public schools and universities.5 None of these investments could have been justified solely on the basis of a private cost-benefit calculation. Initially, both the Interstate Highway System and the air transportation system were used by a relatively small share of the population, often traveling for business purposes. Yet everyone contributed to the cost of the public investments through:

  • Preferential tax treatment (e.g., exemption from property taxes and tax-free financing of public debt);

  • Collection of excise taxes on gasoline used on city streets (the construction, maintenance, and operation of which are paid for by property taxes) to finance construction of intercity highways; and

  • Deliberate cross-subsidies (e.g., distribution of gasoline excise tax revenues from urban to rural areas).

The justification for public expenditures on these infrastructure systems was based on the "positive externalities" and the economic development they generated. That is, beyond the benefits realized by direct users, these investments contributed substantially to economic growth and development in the local, regional, and national economies. Investment in infrastructure can be justified by the fact that what consumers have to spend on goods and services depends on what they earn as workers. It is inconceivable that U.S. workers could have experienced the same growth rates in productivity, income, and standard of living in the postwar period without these infrastructure investments. By the same token, the recent slowdown in productivity growth and falling real incomes reflect, in part, declining infrastructure investment relative to our competitor nations.

Although the telecommunications infrastructure has been mostly privately owned and operated, telecommunications policy in the United States was, for fifty years, based on the same basic principles as public-owned infrastructure. In lieu of public investment, the United States used industry regulation to reduce the risk of, and ensure reasonable returns on, telecommunications infrastructure investment in order to induce sufficient investment of private capital. The goal of universal service was based on a recognition of the positive externalities of additional customers on the network and the stimulus to economic development.

Even though we have achieved universal service, we should still remember the principle of economic development on which it was based. In fact, the principles of universal service, positive externalities, and social overhead capital are as applicable to the next generation of telecommunications services as they were to the last. Much of the value of integrated digital services to any given user, for example, will depend on how many others have access to and are interconnected with them. These externalities are especially powerful in complementary industries, such as information services. Capabilities built into the public switched network could greatly facilitate access to, and thereby demand for, enhanced information services. This is especially true for small-business and residential users, who have neither the resources nor the expertise to design, build, and operate their own private communications system, as do large corporate and governmental users.

In addition to the positive externalities, infrastructure investment in telecommunications improves the quality of services, increases the number of services, and reduces the costs of those services. Thus, telecommunications investment generates substantial benefits to the users of

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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telecommunications services. In the past decade or so, telecommunications services have literally revolutionized many industries; in virtually all industries and sectors, telecommunications services have generated or have demonstrated the potential to generate major productivity gains. Five recent studies of economic development support my conclusion that telecommunications services are playing an increasingly important role, especially in the high-technology, knowledge-intensive industries that generate skilled jobs and a high degree of learning on the job.

First, a study by the Organization for Economic Cooperation and Development (1988) found extraordinarily rapid growth in the importance of telecommunications services to business users in all member nations, with crucial effects on international competition in telecommunications-intensive industries, especially financial services (banking, insurance and securities, commodities, and foreign exchange trading), publishing and information services, wholesaling and retailing.

Second, in a study of the impact of information technologies on service industries (financial services, health care, insurance, and publishing), James Brian Quinn (1987) found:

  • Substantial forward linkage economies and externalities, including realization of economies of scale and economies of scope (the capacity to provide entirely new service products through the same service network);

  • A substantial increase in "output complexity" (the quantity and quality of services available to customers);

  • A blurring of industry boundaries through functional cross-competition; and

  • Improved international competitiveness, through the locational decisions of manufacturers who use these services.

One of the most valuable "downstream" benefits of telecommunications services that Quinn found is the increased geographic extensiveness of user industries. In urban areas this extension improves accessibility and enhances competition among providers of goods and services (e.g., automated teller machines competing with branch banks; telemarketers competing with local retailers). In rural areas the geographic extension of services through telecommunications often means a substantial improvement in the quality and variety of services available to rural consumers and businesses, or even the difference between having affordable access to a service or not (e.g., remote health care services).

In a recent extension of his work, Quinn found that telecommunications can make significant contributions to increased productivity and improved competitiveness in manufacturing as well. In Intelligent Enterprise, Quinn (1992) explores the revolutionary changes in organizational and industry structure that are being driven by the application of knowledge and information, noting that:

[d]iscussions concerning America's manufacturing competitiveness have consistently overlooked an area that offers major productivity leveraging possibilities: the manufacturing-services interface. On the one hand, service companies have become some of the most important customers, suppliers, and coalition partners for many manufacturing concerns. U.S. service enterprises are both near at hand and are among the world's most efficient performers—surpassing the services productivity of virtually all other advanced industrial economies, especially Japan. Major opportunities exist for manufacturers to exploit U.S. service companies as major customers, as lead companies or co-developers for new products, as potential suppliers, as value-adding advisers or market intermediaries, and as sources of valuable information and distribution clout in their markets. (p. 208)

In order to realize this potential, Quinn urges increased investment in communications infrastructures and regulations that are "goal-oriented rather than means-specifying" (Quinn, 1992,

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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pp. 432–433). By "goal-oriented," Quinn means regulations that use incentives to stimulate desired performance, rather than attempting to mandate the means of achieving such performance through "command-control" regulations.

Third, in a study commissioned by the state of New York, Coopers and Lybrand found that purchases of telecommunications services by businesses in the United States were growing at the rate of 11.8 percent per year, compared with gross national product growth rates averaging 2.5 percent (Coopers and Lybrand, 1987). Employment is growing fastest in "telecom-intensive" industries. Even though the real prices of telecommunications services have been declining, purchases of telecommunications services are a growing share of business costs. Consequently, business users are more price sensitive and mobile, so the local cost and quality of telecommunications services play an increasingly important role in business location decisions. Telecommunications can also geographically extend the workplace; by so doing, telecommuting can enhance the quality of workers' and families' lives, bring economic opportunities to rural areas, and aid in reducing congestion and air pollution in urban areas.

Fourth, in a study commissioned by the New Jersey Board of Public Utilities, Deloitte and Touche (1991) found that:

  • "As New Jersey continues to move toward an information services-based economy, today's local exchange carrier network will increasingly constrain users' (especially residential and small business users) ability to fully participate in the Information Age";

  • "A significant opportunity exists to advance the public agenda for excellence in education through improvements to the telecommunications infrastructure";

  • "Strong motivation, especially in the improved quality of care and cost reduction, exists for increasing the use of telecommunications and information technologies in the health care industry in New Jersey"; and

  • "Public policies that encourage deployment of an advanced telecommunications infrastructure are essential for New Jersey to achieve the level of employment and job creation expected in the state." (p. I-3)

Fifth, on the basis of an extensive survey and focus group interviews of small businesses, the Illinois Task Force on Advanced Telecommunications and Networking (1992) concluded that:

  • "All enterprises are becoming more information intensive and … [the] Illinois communications and computing infrastructure will define state economic development capabilities in the future"; and

  • "A robust telecommunications infrastructure is vital to meet the requirements of education and training, libraries, health services, safety, and other social components which collectively create the quality of life." (p. 9)

Each of these studies has confirmed that the direct user benefits, positive externalities, and economic development benefits of telecommunications are, if anything, growing over time. For an increasing number of industries, access to advanced telecommunications services will be essential to competitive advantage, possibly even competitive survival, in global markets. Until recently, though, little or no thought was given to the implications of U.S. telecommunications policy for international competition, perhaps because the United States was a hegemonic economic power in the world. That extremely parochial view of the world is increasingly out of touch with current

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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economic and technological reality, especially considering what has happened and is happening elsewhere.

In an increasing number of countries, national policies are premised on the idea that telecommunications is a strategic industry, with economic characteristics that require or deserve special consideration in assessing policy alternatives. While the term "strategic industry" is often used indiscriminately (i.e., meaning that an industry is important), there is a rapidly growing literature analyzing the economic conditions and characteristics of an industry that make it strategic. Although that literature is concerned primarily with international trade theory and policy, and hence addresses "tradable goods," much of the developing theory applies to nontradable goods as well and is therefore relevant to telecommunications services (see, e.g., Krugman, 1987; Porter, 1990).

IMPLICATIONS FOR REGULATORY POLICY OBJECTIVES

The central message of these international developments is that state and federal telecommunications policies must, in order for the United States to be internationally competitive in the information age, explicitly acknowledge and incorporate the broader economic developmental benefits of telecommunications services. The United States can no longer regulate telecommunications as if it were a purely domestic industry, when other nations have chosen telecommunications as a leading instrument of national economic development and competitive advantage.

Although the telephone regulatory process has become quite adversarial in recent years, historically there was a very strong social and political consensus regarding the goals and objectives of telephone regulation. Moreover, there was a consensus among policymakers that rate-of-return regulation was the best means of achieving those goals. As the economy becomes increasingly dependent on telecommunications services, though, the consensus over both ends and means has been breaking down, as those involved in the policy process attempt to cope with the revolutionary changes that have occurred, and will continue to occur, in telecommunications.

Changes in telecommunications technology and markets have two crucial implications for public policy. First, the goals and objectives, the ends, of regulatory policy should reflect the growing importance of telecommunications to the economic welfare of households, businesses, and public agencies. This requires that policymakers give added weight to economic development effects in considering policy alternatives. Second, in developing and implementing a regulatory framework, the means to achieve those policy objectives, policymakers should take full account of the dynamics of change in telecommunications, on both the supply and the demand sides. Policies that worked well in the past, in a markedly different industry environment, will not work well in the current and future environments of telecommunications.

Traditional Regulatory Policy Objectives in Telecommunications

The era of stable rate-of-return regulatory policy in the telephone industry spans the period from the 1920s through the early 1970s. The dual system of federal and state regulation was reasonably successful, in large part because there was a strong consensus on policy objectives, which included the following:

  • The primary objective of telephone regulation was, historically, the achievement of universal service, that is, promoting the development of a ubiquitous, affordable telephone network, with prices that account for need (social equity) as well as ability to pay (market). This goal was typically reflected in telephone rate designs that priced some services, such as toll, business services, and custom calling features, above cost in order to keep the price of basic residential service at affordable levels. The subsidy to residential users generally included a preferential price for access and local usage (in many states, flat-rate local calling). The universal service objective was also the justification for geographic price averaging, by which customers in rural areas paid the same rates for service as customers in urban areas, even though the cost of both local and toll service was significantly higher in rural areas.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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  • A second important objective of regulatory policy has been maintaining a consistently high level of service quality, including timely installation of new service; very low "call blocking" rates; very little downtime in the network or subscriber lines; and the ability of the public switched network to withstand or quickly recover from natural disasters and other crises. In unregulated industries, market forces generate a wide range of prices and product qualities. In regulated industries, such as electricity and telephone, the systems were engineered to very high standards, whether or not the revenues from any given class of customers cover the cost of the services they use.

  • An often implicit, but nonetheless important, third policy objective has been rate stability, that is, minimizing changes in rates for a class of services or a class of customers. In the rate design process, substantial weight has been given to the existing rates in order to protect customers from "rate shock" due to sudden, unforeseeable price changes.

  • Providing investors with a fair rate of return has been a fourth traditional policy objective of telephone regulation. Fair rate of return encompasses two purposes: (1) giving investors fair compensation for the risk and time value of capital and thereby (2) stimulating private investment in "social overhead capital," the telephone infrastructure. These twin purposes have been served by limiting competition to reduce economic risk (by granting exclusive franchises) and by reducing financial risk through a steady, predictable rate of return on investment.

Progressive Regulatory Policy Objectives

Even accepting that universal service and other social equity goals must continue to be taken into account, the objectives of telecommunications policy should be changed in recognition that economic efficiency, infrastructure investment, and modernization and technological innovations in telecommunications are increasingly important to the productivity of private enterprises, not-for-profits, and public agencies and, therefore, to the competitiveness of the state economy. To take account of the economic development and productivity-enhancing potential of telecommunications, public policy should explicitly incorporate, and give greater weight to, the following objectives:

  • One only need consider the magnitude of the U.S. trade deficit and federal and state fiscal deficits to understand why efficiency should be given more weight in public policy decisions. Because the United States is no longer a hegemonic economic power in the world, and because national productivity gains have not kept pace with leading competitor nations, the country can no longer afford the "luxury" of public policies that fail to promote economic efficiency objectives. Either policymakers elevate efficiency goals to get better use of and more from the nation's economic resources or they will have to do with fewer resources to meet economic and social objectives. That means (1) either allowing market forces to set prices or, if regulated, allowing prices to reflect market factors to achieve allocative efficiency; (2) using incentives to promote technical efficiency by telecommunications companies and their employees; and (3) reducing unnecessary regulations to achieve administrative efficiencies in the administrative process.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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  • In a predominantly market economy, public policies should attempt to be responsive to market conditions in the industry being regulated and in related industries. Prices, as signals of cost and value, play a critical role in market exchange; therefore, regulators should allow prices to be set by market forces whenever possible or, alternatively, emulate market prices when they do set prices (or pricing bands or rules). Similarly, regulators should, to the maximum extent possible, allow markets to determine what variety of products and services will be offered. Market pressures have increased the rewards of good public policies (i.e., those that stimulate investment, increase usage, and promote economic development in the states). Market pressures have also increased the costs of policies that are not consistent with market conditions (e.g., uneconomic bypass, self-supply, relocation of facilities).

  • Technological innovation is a third critical policy objective for promoting economic development. By facilitating innovation and the adoption of better technologies, policymakers can ensure that users will obtain the benefits of innovation, especially lower costs through productivity gains. Regulators can also promote innovation by enabling the rapid introduction of new services to meet customer needs and by allowing greater pricing flexibility for discretionary services.

  • Historically, U.S. policies toward public infrastructure industries have incorporated, if only implicitly, economic development goals. Accordingly, the United States has been an international leader in public infrastructure investments, which have played a significant role in the nation's economic growth and global leadership over the past several decades. Unfortunately, public recognition of similar economic benefits from private infrastructure investment has lagged. Only recently, as other nations have turned their attention to telecommunications services as a means of promoting economic growth, as an instrument of national economic strategy, have U.S. policymakers begun to take sufficient notice of the positive externalities and other public benefits of telecommunications. Elevating the importance of infrastructure investment among policy criteria can potentially improve the performance of telecommunications industries and the nation's economy.

  • One of the most important steps toward efficiency objectives has been taken by allowing, even encouraging, competition in telecommunications services and equipment. Strictly speaking, competition is not a policy objective but a means of achieving other objectives. Still, because there is such a strong consensus in the United States that competition is desirable, policymakers have often elevated competition to a goal of regulation. Competition is especially effective in promoting efficiency, since market competition drives prices toward costs and causes suppliers to minimize costs. Ultimately, competition can supplant or even eliminate the need for regulation, although in the meantime quasi or partial competition may well make the task of regulators more difficult.

Balancing Competing Objectives

Good public policy decisions require making trade-offs among competing objectives. There will be times when some policy objectives conflict with others; good policy recognizes and balances among multiple policy objectives. Policymakers should not assume these trade-offs are inevitable in

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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all cases, however. The art designing outstanding policies involves finding ways to reduce the trade-off, to get more equity and more efficiency. Properly designed and implemented, policies can reduce trade-offs among competing objectives; the resulting improvements in performance can generate increased efficiency and also pay a consumer "dividend."

IMPLICATIONS FOR STATE REGULATORY POLICIES

Until the 1980s there were few significant differences in state regulatory policies toward common carrier telephone companies. In the past decade, though, the states have taken very different paths in their respective responses to the AT&T divestiture, changes in federal regulatory policies, and a growing recognition of the importance of telecommunications to economic development. From a national policy perspective, this variation among the states is useful in generating experience with alternative regulatory policies—a classic case of "laboratory experiments among the states." It is my position, though, that there are many cases in which state policies are inhibiting the growth and development of the telecommunications infrastructure. States should be encouraged, if not required, to adopt policies that meet certain minimum requirements. In this section I discuss four types of regulatory reforms that some states have adopted or are in the process of adopting.

Reducing Rate Distortions: California's Implementation Rate Design

In Phase 3 of its New Regulatory Framework, the California Public Utility Commission (PUC) has expressed its intent to open its local access and transport areas (LATAs) to competition, with 10xxx dialing, for local, extended area service, zone usage measurement, toll, and 0+ calls. The decision, now pending, would raise the price of flat-rate residential service from $8.35 to $13.00 per month, while maintaining a 50 percent discount for lifeline customers. It would substantially reduce the toll rates of Pacific Bell, the major local exchange carrier in the state: in the 17- to 20-mile band, from 22© to 9.75©/minute and in the 51- to 70-mile band, from 37© to 13©/minute. It would also simplify and expand the applicability of usage discounts, making it easier for customers to choose a rate plan that would minimize the prices they pay for toll services.

Through this decision, the California PUC is finally accepting competition as an essential element of the state's telecommunications policy. By removing a large share of rate distortions—that is, prices that are either significantly above or below economic costs—the reformed policy will increase efficiency, promote economic entry by competitors, and encourage the adoption of information technologies that are complementary to communications usage. Still, the PUC proposal leaves substantially unresolved the following problems: continuation of flat rate pricing (i.e., free local calling for residential subscribers) distorts choices between wireline and wireless technologies. Although reduced in magnitude, continuing residential rate subsidies distort the customer's choice between analog and digital service (i.e., the price differential between subsidized analog service and unsubsidized integrated services digital network (ISDN) service biases customers from adopting the advanced service). The plan maintains price averaging, which distorts the economics of rural service and deters the entry of lower-cost competitors and the development of lower-cost technologies.

So, while the California plan represents a significant step in the right direction, it came only after years of highly contentious proceedings and has still not yet been officially adopted. Moreover, given the rate at which technologies are changing and market competition is emerging, it is apparent that regulators, even if heading in the right direction, have difficulty keeping up with, much less getting ahead, of industry development.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Removing Entry Barriers to Local Exchange Competition

Ameritech has filed a joint state and federal regional plan that offers a quid pro quo: Ameritech would unbundle its local network and open the local exchange market to greater competition, in return for being allowed into the interexchange market. The plan would require physical interconnection and collocation of competitors into Ameritech's central offices with reciprocal traffic arrangements. It would also unbundle all critical network elements: local loop, switching, transport, SS7 call setup, and numbering. It would offer customers a choice of carriers, with usage presubscription, and, as soon as technology allows, 1+ dialing for all toll calls. The plan also would shift the universal service burden to all competitors through a "bulk billing" arrangement.

To be implemented, the Ameritech plan requires the approval of the FCC, the U.S. Department of Justice, and the District Court, as well as the regulatory commissions of the five states in which Ameritech operates as a local exchange carrier. The proposal illustrates the high degree of interdependence between federal and state regulatory policies and between antitrust and regulatory policies. It also demonstrates that timing in regulatory reform is often critical: Ameritech seeks "simultaneous" implementation of opening local markets and allowing it into inter-LATA services, while competitors take the position that Ameritech should unbundle and open the local exchange market first, and then, after a sufficiently large loss of market share, Ameritech could be allowed in interexchange services.

Regardless of whether the Ameritech plan is approved as proposed, it is evident that variations in state policies toward competition are growing. It raises the question of whether the United States can continue to tolerate such large differences in policies that are so fundamentally important to the national interest in telecommunications infrastructure. Pending legislation in Congress could preempt states whose policies prohibit competition in local exchange services. Given the number of states that continue to oppose competition, it may well be in the national interest to adopt such preemptive policy.

Deregulating Noncore Services and Regulating the Price of Core Services: Price Cap Plans

Six states have adopted price caps or rate freezes with no earnings sharing as part of their incentive regulation plans. All of these plans have several key elements in common: they deregulate of detariff services that are competitive or discretionary; they remove limits on the rate of return earned by the local exchange carrier; and they institute price freezes or price indexing for core or essential services. Summaries of each of these plans follow.

Kansas

The main features of TeleKansas, Southwestern Bell's incentive regulation plan, are as follows:6

  • The plan froze basic local residential and business rates for the period 1990 to 1995.

  • Local rates could increase for some customers due to the elimination of some party lines and exchange reclassifications.

  • Bell's long-distance rates were permanently reduced by $17.1 million.

  • Access charges for long-distance calls were cut by $2 million.

  • Bell customers will save about $21.3 million in each of the first two years of the plan and $22.8 million in the remaining three years, for a total of $110 million.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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  • Bell committed to an investment of $160 million over the next five years to modernize telephone facilities, upgrade all customers to one-party service, and eliminate all 911 basic service charges.

  • The plan changed the way Bell is regulated (it removed the regulatory cap on Bell's earnings).

  • Pricing flexibility on certain discretionary products was allowed by shortening the approval process to 20 days from 30 days.

Since its adoption, TeleKansas has resulted in increased infrastructure investment, more new services to justify financially those investments, and rate stability to local service customers. The telephone company had impressive first-year revenue increases while maintaining rate stability and increasing infrastructure investment.

Michigan

Michigan's Telecommunications Act of 1991 essentially replaced rate-of-return regulation with service-by-service regulation. The main features of the plan are the following:

  • Monthly service rates were frozen for all but the smallest local exchange carriers for two years.

  • Residential rates were flat rated up to 400 calls.

  • Basic local exchange rates may not cross-subsidize other services.

  • Access rates continue to be regulated and are capped at interstate rates unless approved by the FCC or upon agreement of the parties.

The deregulation law was passed too recently to draw many conclusions, but no basic service rate increases have occurred since the plan was adopted. There have been some long-distance rate increases.

Nebraska

LB 835 deregulated all telecommunications company rates with one exception: basic local exchange service. Tariffs introducing new services or altering rates for existing services can be implemented 10 days after they are filed at the FCC. Basic local exchange service rates are not subject to traditional rate-of-return regulation. Basic local exchange rates are covered under various provisions of the law: (1) The telephone companies must give their customers 120 days' notice and hold a public informational meeting in each commission district before they can change their rates; (2) consumers can authorize the Public Service Commission (PSC) to review a rate increase if enough of the subscribers affected by a rate increase sign a petition; (3) the PSC can review basic local exchange service on its own motion if rates go up by more than 10 percent in a year.7

Contrary to claims that telephone rates would double in five years, US West's basic service rates did not increase between 1987 and 1991. Opponents of LB 835 have tried to point out that the constant rates are excessive and have somehow missed a downward trend in national average basic local service rates. Comparison of Nebraska's business and residential rates with those of its neighbors, however, suggests that its rates are not discernibly higher or lower and that they have not missed any ''downward trend." In service innovation, LB 835 gave Nebraska an advantage over

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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other states in that it allowed carriers to introduce new services virtually at will. This made it easy for telephone carriers to introduce and test new services (Mueller, 1993, p. 119), which has had a small but measurable effect on investment (p. 138). Deregulation and increased investment are gradually having an impact on Nebraska's technological lead over neighboring states (Mueller, 1993, p. 147).

Vermont

The Vermont Public Service Board approved the Vermont Telecommunications Agreement (VTA) on December 30, 1988. Originally, it was to run for three years but was extended for another two. After a second agreement was withdrawn in 1992, the 1987 social contract was extended through 1997. The main provisions of the VTA were as follows:

  • It eliminated rate-of-return regulation for New England Telephone (NET).

  • It provided NET with substantial freedom to offer "new services" under rates, terms, and conditions of its own choosing.

  • It stabilized local service rates for three years (extended since then).

  • It committed over $280 million for network modernization (completed by the end of 1992).

  • It maintained quality of service in accordance with specific criteria.

The agreement appears to have had generally positive results:

  • Local telephone rates in NET's territory have been stable since 1985. Ninety-five percent of all Vermonters have phones, the fourth-highest rate in the country.

  • NET invested $280 million in five years to upgrade its system. The money would have been spent eventually even without the agreement, but more slowly. The new equipment means development officials can assure potential corporate newcomers that they will not be isolated in Vermont.

  • More new services have been introduced than in any other state serviced by NET—19 new services.

  • The state has spent less time and money regulating NET.

  • Regulatory rules have not changed during the agreement, allowing NET, its customers, and its competitors to plan with more certainty. Less regulation means NET and its competitors can focus more on their businesses and customers and less on regulators (Andrews, 1991).

  • Infrastructure modernization through the VTA was significant (Edelstein, 1991).

In summary, the VTA did not allow NET to earn excessive profits. On the contrary, the expense of modernization and launching new products resulted in lower than expected earnings for NET. Basic local rates have not increased throughout the life of the agreement, and the telephone network has been modernized significantly.

North Dakota

Some key features of SB23208 and SB24409 governing incentive regulation were as follows:

  • SB2320 classified services as essential or nonessential.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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  • Rates for essential services were set by the PSC's price factor formula (basically a form of price caps).

  • Rates for nonessential services are not regulated.

  • SB2440 increased the number of nonessential services and reduced the number of essential services; it also set the price cap in the law.

  • Essential service rates have had limited increases allowed through the price cap: the price cap for US West was increased by 1.665 percent in 1992 and by 0.488 percent for 1993; for 1994 the increase will be 0.6 percent.

SB2440 was introduced to clarify and set into the law the list of essential services to be governed by the price cap and to set the price cap and its productivity adjustment. However, rate increases for essential services appear to have been limited. Furthermore, there seems to be broad public support for continuing and expanding the price cap plan, as evidenced by the broad margin of passage of SB2440.

West Virginia

Some key features of the state's incentive regulation plan include the following:

  • Effective January 1, 1992, an incentive regulation plan was approved until the end of 1994.

  • The plan retained the previous plan's service classification (competitive or discretionary, noncompetitive, and intrastate access services) of an earlier incentive regulation plan and added one more category: services subject to "workable competition."

  • Basic service rates were frozen during the plan (a feature of the earlier incentive regulation plan as well).

  • Under the incentive plan, C&P agreed to accelerate infrastructure investments toward becoming 100 percent digital by the end of the plan (it was on target to achieve this goal one year earlier, by the end of 1993).

The incentive regulation plan appears to have had a significant impact on the financial health of the telephone company while maintaining rate stability for basic local services. West Virginia's improved telecommunications infrastructure has also attracted telecommunications-intensive firms (Peters, 1991). In summary, its incentive regulation plan appears to have effectively maintained local service rate stability while at the same time providing incentives for C&P West Virginia to rapidly upgrade its network capabilities. Through its Office for the Future program, the state, in partnership with the local telephone company, seems to be successfully marketing those advanced capabilities for outside investors to relocate to the state.

CONCLUSION

Given the rate of change and the magnitude of changes that lie ahead, public policies must place greater emphasis on the dynamics of the industry, whereas regulation has a natural tendency to deal with statics, such as controlling prices and restricting competition. State regulatory policies have an enormous impact on local exchange carriers and the telecommunications/information infrastructure. In too many instances, state regulation has become a major obstacle to competition, deployment of new technologies, and development of new services. The best route to the information

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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infrastructure of the future is not through more regulation but through different and less regulation. Where states are moving in the right direction, they should be encouraged and rewarded. Where they are not, the United States has a strong national interest in limiting the regulatory prerogatives of the states, to ensure regulatory policies that, if not identical, are compatible with national policy goals and objectives.

REFERENCES

Andrews, Richard. 1991. "Telecommunications Agreement Scrutinized," Vermont Business Magazine, March 1.


Barr, Francois, and Michael Borrus. 1987. From Public Access to Private Connections: Network Policy and National Advantage. Berkeley Roundtable on the International Economy, Working Paper No. 28, University of California, Berkeley.


Coopers and Lybrand. 1987. State Policy & Telecommunications Economy in New York: Final Report. New York State Office of Economic Development, Albany, New York.


Davis, Stan, and Bill Davidson, 1991. 2020 Vision. Simon & Schuster, New York.

Deloitte and Touche. 1991. New Jersey Telecommunications Infrastructure Study: Report to New Jersey Board of Public Utilities. Deloitte and Touche, Trenton, New Jersey.


Edelstein, Art. 1991. "Changes Due on Telecommunications Pact," Vermont Business Magazine, October 1, p. 27.


Gilder, George. 1989. Microcosm: The Quantum Revolution in Economics and Technology. Touchstone/Simon & Schuster, New York.


Harris, Robert G. 1991. "Telecommunications Services as a Strategic Industry: Implications for United States Policy," Competition and the Regulation of Utilities, Michael A. Crew, ed. Kluwer Academic Publishers, Boston.

Harris, Robert G. 1993. "R&D Expenditures by the Bell Operating Companies: A Comparative Assessment," pp. 245–266 in Regulatory Responses to Continuously Changing Industry Structures, MSU Public Utility Papers, Institute of Public Utilities, East Lansing, Mich.

Hirschman, Albert O. 1958. The Strategy of Economic Development. Yale University Press, New Haven, Conn.

Huber, Peter W., Michael K. Kellogg, and John Thorne. 1992. The Geodesic Network II: 1993 Report on Competition in the Telephone Industry. Geodesic Company, Washington, D.C.


Illinois Task Force on Advanced Telecommunications and Networking. 1992. Report of The Illinois Task Force on Advanced Telecommunications and Networking. Report to Jim Edgar, Governor of Illinois, Springfield, III., April.


Karpinski, Richard. 1992a. "AT&T Strides into Local Loop with Possible McCaw Deal," Telephony, November 9, pp. 8–9.

Karpinski, Richard. 1992b. "Time Warner, MCI Test CATV Bypass," Telephony , December 7, p. 6.

Krugman, Paul. 1987. "Strategic Sectors and International Competition," in U.S. Trade Policies in a Changing World Economy, Robert M. Stern, ed. MIT Press, Cambridge, Mass.


Mueller, Milton L. 1993. Telephone Companies in Paradise: A Case Study in Telecommunications Regulation. Transaction Publishers, New Brunswick, N.J.


National Telecommunications and Information Administration (NTIA). 1988. NTIA TELECOM 2000. U.S. Department of Commerce, Washington, D.C.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Noam, Eli M. 1992. "Private Networks and Public Objectives," Aspen Quarterly (Winter):106–136.

Organization for Economic Cooperation and Development (OECD). 1988. The Telecommunications Industry: The Challenges of Structural Change. OECD Series in Information, Computer and Communications Policy (No. 14), OECD, Paris.


Peters, Eric. 1991. "Telemarketer Opens Bureau in Wheeling," The State Journal, December 1.

Porter, Michael. 1990. The Competitive Advantage of Nations. Basic Books, New York.


Quinn, James Brian. 1987. "The Impacts of Technology in the Services Sector," in Technology and Global Industry: Companies and Nations in the World Economy, Bruce R. Guile and Harvey Brooks, eds.National Academy Press, Washington, D.C.

Quinn, James Brian. 1992. Intelligent Enterprise: A Knowledge and Service Based Paradigm for Industry. The Free Press, New York.


Telco Competition Report. 1992. "FCC's Expanded Interconnection Decision Seen as 'Historic' Step Toward Opening Local Exchange Monopoly to Competition," October 15, pp. 1–8, BRP Publications, Washington, D.C.

NOTES

1.  

For a thorough presentation and analysis of competition in telecommunications, see Huber et al. (1992). For additional evidence on this point, see Barr and Borrus (1987). See also Noam (1992).

2.  

See Huber et al. (1992), especially Chapters 2 and 4.

3.  

For a comparison of R&D expenditures by U.S., European, and Japanese telecommunications equipment manufacturers and public telephone operators, see Harris (1993). In a paper presented to the Telecommunications Policy Research Conference in 1989, "Research and Development in Telecommunications—An International Comparison," Thomas Schnoring showed that by 1986, Japanese telecommunications firms had already achieved a higher "technological potential" than U.S. firms overall and had significant leads in optical fiber, image communication, and general picture transmission (Figure 4/1 and 4/2 at pp. 17-18). "Strategic Uses of Regulation: The Case of Line-of-Business Restrictions in the U.S. Communications Industry," by Robert T. Blau and Robert G. Harris, found that among 13 leading global suppliers of telecommunications equipment, the number of electrical patents awarded annually to European and Japanese firms had grown much faster from 1984 through 1989 than those of U.S. firms (Figure 3, p. 183). That study further shows that among the same 13 companies the "relative technological strength" of the U.S. companies remained about the same from 1984 to 1989, while that of the European and Japanese suppliers grew markedly (Figure 4, p. 184). Finally, the study shows that the global market share of the U.S. companies fell by about half from 1984 through 1989, while the shares of European and Japanese firms grew substantially (Figure 5, p. 184).

4.  

In reference to the FCC's September 17, 1992, order in Docket 91-141.

5.  

For an elaboration of this discussion, see Harris (1991).

6.  

Summarized from "State Modifies Bell Plan to Save Customers $110 Million," United Press International, February 2, 1990.

7.  

For more detail on the legislation, see Mueller (1993), from which this description was drawn.

8.  

1989 North Dakota Session Laws, Chapter 566.

9.  

1993 North Dakota Session Laws, Chapter 469.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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The Prospects for Meaningful Competition in Local Telecommunications

Dale N. Hatfield

INTRODUCTION

The purpose of this paper is to explore the prospects for meaningful competition in the provision of local telecommunications services. This topic is important (1) because of its relationship to the line of business restrictions that were placed upon the Bell operating companies (BOCs) as a result of the Modified Final Judgment that produced the breakup of AT&T and (2) because of the efforts of local exchange carriers more generally to be deregulated in the provision of exchange and exchange access services and to expand into information services and other adjacent competitive markets.

PROSPECTS FOR COMPETITION

Cable Company Competition with Telephone Companies

It is useful to look at the public switched telecommunications network (PSTN) as being composed of five parts: (1) the terminal equipment and inside wiring portion on the subscriber's premises; (2) the subscriber access or local loop portion of the network between the subscriber's premises and the local switch or central office; (3) the local switching portion; (4) the metropolitan-area portion of the network interconnecting those central offices and the "points of presence" or switching systems of the long-distance carriers; and (5) the interexchange or long-haul portion of the network. To these five parts—customer premises equipment, local loops, local switching, metropolitan-area/interoffice transport, and the interchange network—it is also useful to add a sixth by dividing the local exchange switching systems into two parts: (1) basic call processing, that is, the lower-level functions associated with making connections between and among subscriber lines and interoffice trunks, and (2) the higher-level, software-based service logic functions and their associated data bases. Of course, it is this separation of basic call processing from the service logic and associated data bases that is leading to the creation of the "intelligent network" and the offering of services like personal number calling.

NOTE: The views and opinions set forth in this paper are those of the author. They do not necessarily reflect the views of the Annenberg Washington Program in Communications Policy Studies of Northwestern University.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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At one time—not really so long ago—all of these segments of the network were regarded as being part of one large natural monopoly. The notion that the entire network—all six parts—exhibited natural monopoly characteristics was challenged by (1) rapid technological changes (such as the development of microwave radio) and (2) a lot of rethinking on the part of policy analysts and regulators. There is no need to repeat the regulatory history here, but, briefly stated, the customer premises equipment and long-haul portions of the network were "unbundled" from the four portions of the local exchange network—subscriber access, local switching (2 parts), and local transport. Competition was then allowed in these unbundled portions, and that competition is now well established in both areas. It is probably fair to say that many policy analysts, initially at least, believed that the local exchange network—composed of the four remaining parts—still constituted a natural monopoly.

Viewed in a historical context like this, it is not really too surprising that the natural monopoly status of the local exchange network is now being challenged by (1) continuing rapid technological changes and (2) further rethinking about the scope of the monopoly on the part of policy analysts and regulators. Consequently, as a result of actions at the federal level (in terms of interstate services) and by selected public utility commissions at the state level (in terms of intrastate services), competition is emerging in the transport portion of the local exchange network and, to a very limited extent, in local switching. Furthermore, from a technological perspective at least, there are even some prospects for intermodal competition (e.g., from wireless technologies alone or from a combination of cable television and wireless technologies) for the local loop itself.

The cable television industry is now deploying fiber in the distribution portions of its networks and otherwise studying and beginning experiments with the next generation of cable technology. Those developments and experiments, which include "fiber to the neighborhood," conversion from analog to digital transmission, digital compression, and advanced forms of packet switching, are aimed at providing dramatic increases in capacity (e.g., to 500 television channels or beyond) and increased reliability while serving as a future platform for the introduction of two-way, multimedia services (such as interactive games and distance learning) and, potentially, traditional voice and data services as well.

However, there are numerous technical uncertainties and other constraints associated with the provision of the latter types of services. For example, there are the noise ingress problems associated with the use of the "tree and branch" cable architecture for the upstream transmission of such signals, the limitations associated with inexpensive cabling and other devices (e.g., splitters) used by many consumers within their homes, the added complexities in terms of the radio frequency modem needed on the customer premises to allow two-way communications and in interfacing existing analog telephone equipment to that modem.

Other major constraints are that cable companies lack (1) the necessary switching systems to route ordinary telephone calls among subscribers or between subscribers and long-distance networks; (2) the sophisticated and very specialized network management (operational support systems) for the provisioning, administration, maintenance, traffic management, service evaluation, and planning and engineering associated with switched services; (3) specialized billing systems capable of handling the full range of local exchange telephone services and the associated large volume of individual calls or transactions; and (4) the technical arrangements for routing traffic between and among individual local cable television systems and between such systems and the incumbent local exchange telephone carrier.1

In addition to the above limitations, the following points must also be considered when considering competition by the cable industry:

  • The industry is by no means unanimously in favor of pursuing even specialized aspects of the telecommunications business, let alone ordinary local exchange and exchange access services. In other words, some cable firms may be very slow to offer (if ever) anything except entertainment video and closely related services.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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  • Because cable television franchises are typically awarded on a community-by-community basis, the industry is badly fragmented on a geographical basis. In a typical metropolitan area (let alone over an entire local access and transport area served by a Bell operating company), it is not unusual to find literally scores of individually franchised systems owned by a relatively large number of different cable multiple system owners.

  • Those firms that are exploring the telecommunications business (especially switched services) have not reached any final agreement on the technical details of the architecture that they will employ. Because of the differences in approaches in this early stage of development and the diversity of cable system ownership in a particular region, the initial services offered are apt to be highly fragmented and therefore of limited utility.

  • While the economics for upgrading cable networks to expand entertainment services are well established, there is still considerable uncertainty about the economics of providing ordinary switched telephone services.

  • Building on the previous four points, the well-publicized trials that the cable companies are currently carrying out are more in the nature of experiments as they relate to the provision of ordinary telephone (i.e., nonentertainment) services.2 To the best of my knowledge, there are no cable television companies in the United States that are offering regular "dial-tone" services on a tariffed basis at this time [Fall 1993].3

In addition to the above, and beyond any direct de jure barriers to entry, there are host of other de facto constraints to cable companies and other potential competitors entering the local exchange telephone business. These restrictions include, inter alia, the following:

  • Lack of agreements and standards for the efficient and economical interconnection of competitors with the incumbents' local exchange networks for the exchange of local traffic;

  • Difficulties associated with accessing pole lines, ducts, rights-of-way, radio sites, and buildings necessary to construct competing facilities;

  • Absence of nondiscriminatory access to unbundled information (e.g., data bases) and services in the incumbent carrier's network necessary for the transmission and routing of telecommunications services;

  • Absence of the ability to resell the incumbent's telecommunications services and network functions and skewed pricing structures that preclude entry into some segments of the local exchange market; and

  • Incumbent's control of numbering plans and lack of local number portability.4

Because of these restrictions and the simple size of the task required to duplicate the existing local exchange network, the cable companies are not in a position to offer significant competition to incumbent local exchange telephone companies in the short to medium term, even if such competition were authorized by regulatory authorities.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Telephone Company Competition with Cable Companies

In the past, local telephone companies or local exchange carriers (LECs) have been limited technologically in their ability to provide cable television services by the inherent bandwidth limitations of the twisted-pair copper cable deployed in the local loop portion of their networks. The LECs are exploring two different approaches to overcoming these limitations.

One approach is known as asymmetrical digital subscriber line (ADSL) and is based on the use of sophisticated digital signal processing techniques for one-way transmission of broadband digital signals plus ordinary two-way voice conversations over a single pair of wires (i.e., the local loop). The ADSL technology, which would retain the classic star topology of the existing network, coupled with advances in digital signal compression, would, potentially, allow simultaneous transmission of several video signals to the home.

Basically, the ADSL technology involves trying to squeeze the last increment of capacity out of a network that was optimized for narrowband voice transmission. However, there are significant technological and economic risks associated with further development and deployment of this technology. These risks are as fundamental as whether the quality of the signal will be sufficient to meet customer needs, whether a sufficient number of video signals can be delivered simultaneously, whether the performance will be adequate on the copper pairs installed many years ago, and, since there are distance limitations associated with the technology, how customers beyond a certain distance from the central office will be served. These risks are apparently so great that some telephone companies in the United States appear to have rejected the ADSL approach, and only one company seems to be strongly pursuing the technology in field trials.

The other approach being explored by the LECs to overcome the inherent limitations of their existing network involves replacement of the twisted-pair copper cable with fiber optic cable and its associated electronics. The telephone companies' highly publicized original vision called for running fiber optic cable all the way to homes, the so-called fiber-to-the-home (FTTH) architecture. However, as noted in a recent article in a telephone industry trade publication (Wilson, 1993), "The local exchange carrier community's once-grand plans for running fiber optic cable into every American home came to a screeching halt in 1989, colliding hard with the wall of high costs" (p. 9).

The industry retreated from the FTTH vision to a configuration that involved proposing to run fiber close to a group of customers so that the cost of the necessary electronics could be shared among a number of households. This configuration, which is now being tested, is referred to as fiber to the curb (FTTC). However, there are still significant unresolved technical issues relating to this more modest vision of the telephone companies. These include such fundamental questions as whether the network (1) should be active or passive or some hybrid of the two, (2) should utilize analog or digital transmission or some hybrid of the two, (3) should be configured with a star or tree-and-branch topology or a logical hybrid of the two, and, (4) for the star topology, whether it should be a single or double star.

This uncertainty is further illustrated by recent indications that some LECs may retreat even further and adopt a "fiber-to-the-neighborhood" architecture that in many ways is similar to the hybrid approach being deployed by the cable industry. Given the technical uncertainties associated with FTTC, it is not surprising that there are considerable economic uncertainties associated with the FTTC approach, to say nothing of FTTH.

Not only are there still significant uncertainties associated with the technology and costs associated with potential telephone entry into the provision of broadband services, there are also significant uncertainties about whether the added revenues generated by the provision of entertainment video services would be sufficient to cover the added costs. For example, one of the most publicized telephone company experiments with two-way cable (GTE's experiment in Cerritos, California) was recently characterized as a "flop" (Lippman, 1993).

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Moreover, in competing for the delivery of entertainment video programming, the telephone companies face cable companies that have already constructed broadband coaxial cable networks that are now available to roughly 96 percent of the television households in the United States. Furthermore, as suggested above, cable companies can greatly expand their available capacity and achieve significant one-time efficiency gains by introducing fiber in the trunk and distribution portions of their networks, while retaining use of the existing broadband coaxial cable connections to individual residences. Finally, the cable television revenues themselves are at risk because of the increased competition from terrestrial-based multichannel multipoint distribution systems or "wireless cable" systems, the imminent launch of a high-power, high-capacity direct broadcast satellite system, and the "cellular-like" wireless systems operating in the upper regions of the microwave spectrum near 28 GHz. These competitive threats are enhanced by the availability of the same digital compression techniques that will enable the significant expansion of cable television system capacity as explained above.

The issue of LEC investment in broadband facilities is complicated by the interaction of the incentives created by the mature state of the market for ordinary local exchange services, continuing rapid technological changes, and the nature of traditional economic regulation. Regarding market maturity, one of the most fundamental factors facing the LECs is that "universal service" has largely been accomplished and their basic business, as measured in terms of the number of access lines, is growing at the slow rate of only a few percent per year. Thus, there is very little opportunity for substantial growth in their basic business.

Moreover, their basic local exchange telephone business is, by and large, still under traditional rate-of-return regulation. With traditional rate-of-return regulation, expenses are essentially passed through to ratepayers, and annual profits are determined by the product of the allowed annual percentage rate-of-return and the net investment (i.e., original investment less accumulated depreciation) that has been made to provide the regulated services. However, the falling costs of switching and of interoffice transmission, and the introduction of pair-gain systems in the loop, combined with more rapid depreciation, have created a situation wherein the net investment (i.e., the "rate base") is trending downward. In a nonregulated industry, this would be welcome news because increased capital productivity would allow increased profits and/or decreased prices. But with traditional rate-of-return regulation, increased capital productivity reduces the absolute level of profits. This decrease in the absolute level of profits due to falling net investment has been exacerbated by the falling cost of capital (and hence the allowed rate of return) over the last few years.5 In short, without some fundamental change in strategy or regulation, the LECs/BOCs face the prospect of "disinvestment" and decreasing total profits in their basic business.

Thus, as long as the established LECs are rate-of-return regulated—or even if a strong component of rate-of-return regulation remains under alternative forms of regulation as is typically the case—there is a strong reason for them to invest in fiber irrespective of demand. Indeed, the potential drop in the absolute level of profits without the immense investment associated with fiber-in-the-loop may largely explain the massive public relations, litigation, and lobbying efforts that they have unleashed to convince policymakers, regulators, and the general public that the investment is not only prudent but absolutely required to assure the competitiveness of U.S. firms in world markets.

There are other advantages to the BOCs of deploying fiber, especially in downtown metropolitan areas where they are beginning to face competition from competitive access providers such as Teleport and Metropolitan Fiber Systems. By investing in fiber in these downtown areas, they not only respond to the nascent competition but, by over-investing, can also discourage additional entry. Despite these other advantages, the need to boost investment is clearly a major motivation for the LECs' desire for fiber—especially in the residential and small-business markets.

Another problem with LEC investment in fiber is that, as long as they have monopoly power in the provision of local exchange services, they have the incentive to load the bulk of those

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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investment costs on ordinary ratepayers in order to subsidize the provision of new broadband services. In addition, as a practical matter, it is almost totally beyond comprehension that regulators would allow a local telephone company to fail if there were not alternative providers of service available. Thus if uneconomic investments by LECs are made in broadband facilities in the subscriber access portion of the network, the inevitable result will be that ordinary ratepayers—not the stockholders of the local exchange company—will be stuck with the bill. This is especially true if such investments are made at the behest of the regulators themselves.

Because of all of the foregoing and the simple size of rebuilding the existing local exchange network, the telephone companies are not particularly well situated to compete with the cable companies for provision of broadband entertainment services unless potentially uneconomic investment is artificially stimulated by policy and regulatory actions (or inaction).

SUMMARY AND CONCLUSIONS

Despite the current hype that surrounds the issue, there are significant uncertainties about whether head-to-head competition will actually develop between telephone companies and cable companies in the provision of local services. Even if the existing legal barriers to entry are eliminated, there remain significant technological, economic, and marketplace uncertainties concerning the development of such competition. If competition does develop between the two industries, it will be slow in coming, and it may well be limited to the provision of certain specialized services or network components, rather than for the basic services that lie at the heart of each industry's current business. Furthermore, if, over time, these barriers and uncertainties are overcome, the resulting industry structure may consist of little more than an oligopoly with only two major players.

In either case—with limited competition in adjacent sectors of the market or a two-player oligopoly—the resulting rivalry would hardly meet the test for robust competition that would justify full deregulation of the LECs. Thus, policymakers and regulators would be well advised to exhibit a healthy amount of skepticism regarding the lifting of existing line of business restrictions and deregulating LECs without adequate safeguards.

REFERENCES

Lippman, John. 1993. '''TV of Tomorrow' Is a Flop Today," Washington Post, September 1, p. F1.


Wilson, Carol (ed., Telefocus column). 1993. "Bellcore Revisits the Residential Broadband Cost Question," Telephony, July 26.

NOTES

1.  

Affadavit of Richard R. Green in the United States District Court for the Eastern District of Virginia, The Chesapeake and Potomac Telephone Company et al. v. United States of America et al., May 20, 1993.

2.  

Affadavit of Richard R. Green, May 20, 1993.

3.  

In the United Kingdom, cable companies are beginning to provide ordinary local telephone service in competition with British Telecommunications.

4.  

These barriers were identified and discussed at the Eighth Annual Aspen Institute Conference on Telecommunications Regulation.

5.  

The potential decrease in profits also explains, to a substantial degree, the LECs/BOCs interest in "price cap" or "incentive" regulation, which essentially decouples prices from costs.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Regulation and Optimal Technological Change: Not Whether, But How

Nina W. Cornell

The topic of this panel is how regulation has impeded the timely introduction of cost-effective new technologies and even encouraged adoption of new technologies that, although new, are not the most cost-effective. I have been asked to address this question from the vantage point of an interexchange carrier. However, I believe that the vantage point is the same as that of any entrant that wants to provide services but is not the provider that supplies the network with which end users initially connect. The problem I have with the formulation of the panel's topic is that it implies that if regulation somehow went away, a more efficient future—with speedier and better technological change—would await us. I do not believe that.

The technological change that an industry or sector experiences is in part a function of its market structure and the presence or absence of barriers to entry. In telecommunications the choice for market structure is either to have a monopoly or to use regulation to keep the door open to the possibility for multiple-firm supply. Which of these two choices we select and, if we select the second, how we implement it will have profound effects on the future pace and direction of technological changes.

I believe the history of telecommunications from its beginnings to the end of the monopoly era shows that a monopoly market structure does not maximize the likelihood of promoting the most cost-effective technology at the most efficient pace. As the telecommunications system was opened up to entry in different places, starting in the 1970s particularly, the pace of deployment of new technologies and functionalities also accelerated.1 Only if we maintain and even expand the opportunities for multiple-firm supply and new entry will the goal of promoting the most efficient pace and direction of technological change be met. To maintain or expand the opportunities for multiple-firm supply, however, requires regulation in its broadest sense. This is because telecommunications is a two-way network system.

In all two-way network systems, government has had to play a bigger or smaller role in order to ensure interconnection between the parts of the system. This is because two-way networks must have some kinds of nodes where the different parts of the network pass traffic in both directions between the parts. If any one player completely controls the nodes, that player also controls the entire system. Any would-be entrant would have to build a complete duplicating network and induce all customers to switch, as otherwise the new network would not serve the two-way function that is required.

In order to have the possibility for multiple-firm supply when the sector involves a two-way network need, government must either own the nodes, as it does with airports; own the approaches to nodes, as it does with roads; or regulate the terms and conditions of interconnection, as it does with railroads and telecommunications. If government does not continue to regulate the terms and

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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conditions of interconnection in telecommunications, the history of this sector of the economy shows that those terms and conditions will be used to remonopolize most or all of the sector.

Technically, this outcome is possible because of the way the two-way distribution of traffic occurs. Each end-user connection to the network (or to a network of networks) must have a unique address number, whether that number is the one originally dialed (as with current ordinary local and toll calls) or is the number to which a dialed number is translated for routing (as occurs today with 800 calls). This unique address number is what the networks themselves use to route calls. When a call is placed by a calling party, that unique address number is set to be the termination point. Most customers, particularly residential and small-business customers, will have only one or a very small number of such terminating addresses and are likely to want them all supplied by a single company, even should local exchange competition be a reality. I base this conclusion on the way the toll market has worked: almost all interexchange companies use the billing services of the local exchange companies for residential customers, at least in part because of those customers' preference for a "single bill." Moreover, at least for a while, even where a customer uses more than one local exchange supplier, the telephone number actually dialed by the calling party will determine which of those lines is the destination point.

The company that controls that termination point has dominance over the pricing of terminating at that address within a very broad range of possible prices. For most kinds of what we today call plain old telephone service calls—local and toll calls—the company that receives the origination of the call will have no choice but to pay what the company that controls the terminating address charges for the termination. This is because the choice of which company will control the terminating address is not made by the company of the customer originating the call but by the end-user customer on the basis of the cost he or she has to pay, which is only for outgoing calls. The cost to the originating company of trying to convince the terminating customer to change that choice is not likely to be low enough that the originating company could afford to try to induce the terminating customer to change his or her provider of that connection to the network. Thus, the company that controls the terminating address will continue to have a bottleneck monopoly over all calls sent to that address, even if not over all customers in a geographic region.

Regulation of the terms and conditions of interconnection will have to take into account a number of ways the company that controls the terminating address might use (abuse) that control, absent regulation, to remonopolize the market, if multiple-firm supply is to be able to bring new technologies to market tests. The first way the company might try to regain a monopoly is to refuse outright to interconnect at all. This is also the easiest abuse to prevent. As important for future possible technologies, however, is the potential refusal of the terminating company to interconnect except at a few select locations in its network. This selectivity can be used to retain a monopoly over a larger amount of the actual transmission or to insist that additional functions will only be supplied by the terminating company, not the originating company. A refusal to interconnect at a particular point in the network can prevent certain technologies from being introduced at all or from being introduced in as timely or as extensive a manner as would have occurred if interconnection had been allowed where the supplier of that technology had wanted.

Refusals to interconnect are not the only way power over the nodes can be exercised to influence market structure and, with it, technological outcomes. The same results can be achieved by allowing interconnection but then setting prices that in fact deter or prevent the ability to use the interconnections successfully. In this regard it is not just the setting of too high a price, per se, but also the relationship of the price for interconnection to other prices that can have pervasive effects on the future pace and direction of technological change. The adverse effect of cross-subsidization on future technological change has been touched on by Robert Crandall (in this volume). Cross-subsidies by an incumbent firm with control over the nodes can be used to impede or block entry by other firms into the provision of one or more services. This in turn prevents those other firms from bringing new technologies and new functions to the market.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Much less often addressed, but a much more common danger, is the likelihood of establishing price squeezes that achieve the same goals but without having to price any services to end users below cost. The formerly monopoly local exchange providers have succeeded in several cases in establishing price squeezes and getting to continue them, reducing or eliminating the ability of other firms from effectively challenging the former monopoly provider's dominance over the supply of those services. Price squeezes by local exchange carriers have been demonstrated in the case of pay phones in a number of state regulatory proceedings.2 The battle that continues to rage over whether local exchange carriers will be required to impute charges for bottleneck monopoly functions into their end-user rates also demonstrates the existence of price squeezes today.3

Local exchange carriers—for example, GTE in Oregon and Pacific Bell in California—continue to argue that they should not be required to impute the charges at all.4 Moreover, they argue that if they must impute at all it should be done over such a broad aggregation of services as to allow some of the most competitive services to escape the requirement. This argument appears, for example, as a claim that any imputation requirement should not apply on a service-by-service basis within intra-local access and transport area (LATA) toll, but only to the entire category of toll services collectively. Because of the continued denial of equal access for intra-LATA toll, the most competitive portion of this market is the segment that interexchange carriers mostly supply using special-access facilities. An imputation requirement applied only to all toll services collectively imposes no effective constraint on how the local exchange carrier prices the services that compete with the interexchange carriers' special access-based services. When imputation is not required, the result is that the local exchange carrier can price the service at a level no other carrier can match because of the price that the other carriers must pay for access.

This is the same technique that will most likely be used to remonopolize if proper regulation over interconnection prices is not maintained even in a world of multiple suppliers. This is particularly important because multiple suppliers are not likely to be able to enter with services offered to all customers in a broad geographic region. The incumbent supplier of network connections—the local loop—is likely to try to impose interconnection rates on competing providers that are higher than what it recovers in its own charges for the service for which termination is sought, as Bell Atlantic tried to do in Maryland, for example, for local exchange terminations to Metropolitan Fiber Systems.5 If permitted to price this way, the current providers of local loop facilities could underprice all other providers in all markets in which they are allowed to operate.

Thus, the choice facing the government in telecommunications is not whether to regulate but where to regulate, and how, if it wants to promote the ability of the market to test and adopt most readily new cost-effective technologies. Whatever answer government chooses will have a significant influence on the future pace and direction of technological change, because it will determine into which parts of the whole telecommunications system new ideas, technologies, and services can most easily be subjected to a market test. In other words, regulation cannot be neutral in its impact on the future pace and direction of technological change.

Regulation will have to determine the nature and extent of physical unbundling that will be required of those firms that supply the first connections to end users. How unbundled those networks are forced to be—which means at what points other firms can interconnect—will determine how much other firms can contest in the market such functions as the amount and direction of the intelligence in the network, the functions that can be added to basic call processing, and the like.6 Other firms can only contest the choices made for these elements if they can interconnect at locations that enable them to offer substitutes for the choices made by the initial carrier.

Regulation will also have to determine the prices paid for various forms of interconnection. In this regard, regulation will have to determine three aspects of the price. The first is the overall level of each price. The second is the price for one form of interconnection relative to other forms of interconnection. The third is the price for each form of interconnection relative to prices set by the owner of the nodes for services provided directly to end users. Each of these aspects of the

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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price for interconnection can have a direct impact on the future pace and direction of technological change.

If interconnection prices are set very high, demand for the services that must interconnect is suppressed, with the result that less attention may be paid to those services by those investigating new technologies and functions. Very high interconnection prices could also push some users to turn to less efficient technologies that can serve their needs but that avoid the need to pay the high interconnection prices. Because such options are only available to some telecommunications users, the result is a loss in efficiency over time.

If the price for one form of interconnection is high relative to another, firms using new technologies will tend to try to adapt those technologies to be able to use the less costly (to them) form of interconnection. This also will have direct impacts on which technologies get adopted and how efficiently they are used. If the relative prices for different forms of interconnection vary based on factors other than the underlying cost differences, these variations in how future technologies develop will not be as efficient as they would have been in the absence of interconnection price differences not based on cost differences.

If the price for interconnection is set such that any firm using interconnections faces a price squeeze relative to the price charged for relevant end-user services by the firm controlling the nodes, the firm using the interconnections will have less chance to prove in the market the possible superiority of its technology or functions. Once again, the result will be less efficient than would have been the case in the absence of a price squeeze and will have a deleterious effect on the pace and direction of future technological change.

The challenge, thus, is to accept that some regulation is necessary and to design it to allow the greatest opportunity for new ideas to have a chance to prove themselves in the market. The necessary regulations involve both the technical aspects of interconnection and the prices to be paid for various forms of interconnection. The first of these two needs means that regulation must address the multitude of issues involved in what has come to be called Open Network Architecture, but it must be done with a greater recognition that appears at present of a need to push the former monopoly firms that provide the first connections to the system for end users to unbundle beyond where their own incentives would lead them to go. The necessary regulation of interconnection prices, however, will not occur until there is recognition that the necessary controls over interconnection prices are not addressed by debating the merits of price caps over rate-of-return regulation.

The problems of rate-of-return regulation are by now widely known. Price cap regulation is offered as a solution that eliminates incentives to avoid new technology or be inefficient in operation. Price caps are also advocated because they may reduce or eliminate incentives to engage in cross-subsidization. This latter claim depends in good measure on the ability to prevent the firm from turning back to rate-of-return regulation if things do not go well for it under price caps, a topic most suitable for debate among lawyers. Price caps, however, do not eliminate the incentive to create a price squeeze and may even facilitate implementing one. Thus, price caps, however beneficial as a means of limiting possible monopoly abuses of end users' prices, do not begin to address the issues involved with pricing interconnections. Moreover, the regulatory requirements necessary to try to control or prevent price squeezes reduce some of the regulatory savings that have been touted as a benefit by those who promote price caps.

The controls necessary to try to curb or prevent price squeezes involve looking in fairly detailed ways at costs versus prices for each service offering, particularly the offerings to end users. The reason is that, to prevent price squeezes, end-user prices must include the same charge for use of the nodes as is charged to those who must interconnect. Without such a nondiscrimination requirement, price squeezes are inevitable. The necessary data from which this part of the necessary regulatory controls must be developed, however, is either the same as, or similar to, the data that have to be collected for rate-of-return regulation. Ending the collection and reporting of these data

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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is one of the "efficiencies" often cited as a benefit of price cap regulation. It is, however, at best only a short-run efficiency if it means that the regulations necessary to promote the widest testing of new ideas and functions cannot be imposed.

NOTES

1.  

See, for example, Report by the Federal of Communications Commission on Domestic Telecommunications Policies, submitted to the Subcommittee on Communications, Committee on Interstate and Foreign Commerce, U.S. House of Representatives, September 27, 1976; and Telecommunications in Transition: The Status of Competition in the Telecommunications Industry, a report by the Majority Staff of the Subcommittee on Telecommunications, Consumer Protection, and Finance, U.S. Congress, House, Committee on Energy and Commerce, 97th Congress, 1st session, November 3, 1981, for two reports of these effects compiled at the time the system was being opened up to entry.

2.  

See, for example, Before the Commonwealth of Massachusetts, Department of Public Utilities, Petition for an Advisory Ruling as to the Competitive Nature of Public Pay Telephone Service, D.P.U. 88-45, 1988-1989; Before the Public Service Commission, State of Florida, In re: Petition for Review of Rates and Charges paid by PATS Providers to LECs, Docket No. 860723-TP, 1990: Before the State of Illinois Commerce Commission, In the Matter of Independent Coin Payphone Association and Total Communication Services, Inc. Complaint to Reclassify Illinois Bell Telephone Company Pay Telephone Service as a Competitive Service in Illinois Market Service Area 1 (MSA 1), Docket No. 88-0412. 1991-1992; Before the Washington Utilities and Transportation Commission, Northwest Payphone Association et al. v. US WEST Communications, Inc., Docket UT-920178, 1993.

3.  

See, for example, Before the state of Illinois, Illinois Commerce Commission, In the Matter of Illinois Bell Telephone Company Petition to Regulate Rates and Charges of Non-Competitive Services Under an Alternative Form of Regulation, Docket No. 92-0448, 1993. This is only on of many cases where a price squeeze has been shown to exist for some toll services.

4.  

See the filings of GTE in Before the Public Utility Commission of Oregon, In the Matter of the Investigation into the Cost of Providing Telecommunications Services, Phase II: Unbundling and Pricing Issues, Docket UM 351, ongoing, and the testimony and briefs of Pacific Bell in Before the Public Utilities Commission of California, In the Matter of Alternative Regulatory Frameworks for Local Exchange Carriers and Related Matters, 1.87-11-033, 1991-1992.

5.  

See the Direct Testimony of Alfred E. Kahn and William E. Taylor on behalf of Bell Atlantic-Maryland in Case No. 8584, Before the Public Service Commission of Maryland, In the matter of the Application of MFS Intelenet of Maryland, 1994.

6.  

For a vivid example of the difference in the level of unbundling sought by entrants and the level local exchange carriers are willing to provide, see the filings of the various parties in Before the Public Utility Commission of Oregon, In the Matter of the Investigation into the Cost of Providing Telecommunications Services, Phase II: Unbundling and Pricing Issues, Docket UM 351, ongoing. This is not the only example of such a discrepancy, however.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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The Future of Telecommunications Regulation: The Hard Work is Just Beginning

Thomas J. Long

INTRODUCTION

This is a time of dramatic change in the telecommunications industry. Traditional monopoly markets are disappearing. Competition in the local loop is coming. Computer and telecommunications technologies are converging. The cable industry is becoming a major force in telecommunications. Each day our newspapers herald another important change.

As we make the transition to a new telecommunications marketplace, particularly as we anticipate enhanced competition, there may be a tendency to assume that it is time for regulators to pack their bags and go on an extended, or even permanent, vacation. My message is that regulators should put the vacation brochures back in their drawers and hunker down for at least 5 to 10 years of more hard work. And, despite all of the changes, most of the hard work will serve the same primary purpose that regulation has always served—protecting consumers and competitors from monopoly power.

A number of trends are now converging to create a serious threat for residential and small-business consumers. The threat is of saddling these consumers with unjustifiably high rates for basic service in a time of dramatically declining costs. Monopoly local exchange carriers (LECs) can use these inflated basic service rates to cross-subsidize their expansion into the video and information services markets. LECs will be able to use the revenue from these excessive rates to gain an advantage over their current and future competitors. Consumers will suffer, not just because they will be paying excessive rates but also because the development of competition will be slowed or even stymied.

At least five trends are contributing to this threat. First, skittish LECs worried about competition are looking to collect as much money as possible from captive customers for as long as possible. Second, regulators may be aiming their sights too far down the competitive road and failing to see the considerable monopoly power that LECs still wield. Third, in a time of tremendous upheaval in the telecommunications marketplace, the LECs and other telecommunications giants can take advantage of their massive resources to argue for a regulatory "paradigm shift" that furthers their interests at the expense of small customers. Fourth, telecommunications giants have shown their adeptness at parlaying regional and national concerns about economic weakness and global competitiveness into much friendlier regulation. Fifth, in the absence of any new tax revenue, monopoly telephone rates are seen as the next best thing to taxes. Unlike tax money, which is used for a public purpose, revenue from higher rates is viewed by the monopoly telephone companies as their money to use as they see fit.

These trends mean that regulators will have to be more vigilant than ever in the coming years to protect consumers from unjust and unreasonable rates. In this paper I highlight two issues

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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that I believe will be particularly important to small consumers. But first, since I have argued that the main purposes of regulation will not change much in the coming years, I want to share my view of those main purposes.

PURPOSES OF REGULATION

I see three traditional purposes of telecommunications regulation. The first, and core, purpose is to protect consumers and competitors against the undesirable consequences of market power. With market power comes the ability to engage in price gouging of customers, to cross-subsidize competitive services through supracompetitive rates for monopoly services, and to engage in other unfair conduct designed to thwart competitors. Regulation is needed to curb such exercises of market power.

The second purpose is to protect consumers and competitors against fraud (and other abuses of customers), unfair competition, and other undesirable behavior that even telecommunications firms without market power might exhibit. Market power can facilitate some of this untoward behavior, but competitive firms can commit fraud and conspire to defeat competitors too. (Monopolies don't have a monopoly on bad behavior.)

The third purpose is to promote universal service. This is a goal of regulation, not primarily to satisfy a collective charitable impulse toward less advantaged segments of society, but rather to reap the enhanced benefits of a telecommunications network to which all are connected. I define universal service as universal access to the level of telecommunications service that is essential for effective participation in society.1

As competition increases, these will still be the main purposes of regulation, at least for the foreseeable future. As for the first purpose, the LECs will continue to have market power in many of their market segments for several years, especially for the services used primarily by residential and small business customers.2 With respect to the second purpose, the challenge of protecting consumers against fraud and other abuses will only increase as the number of competitors and customer confusion multiply. As for the universal service objective, even in a fully competitive marketplace, everyone will be better off if we ensure that essential telephone service is affordable to all groups in society. That will mean continuing to have the general body of customers pay into Lifeline-type funds to support subsidized service for customers needing assistance.

I would like to focus on two issues that are now and will continue to be particularly important to consumers, and therefore should be important to regulators, in the coming years. The first is protecting consumers from becoming the guarantors of the LECs' success in competition. The second is ensuring that consumers don't become involuntary and uncompensated investors in the LECs.

INFLATED MONOPOLY RATES AS A CUSHION AGAINST COMPETITION

As traditional monopoly sectors shrink, the incentives for LECs to flex their monopoly muscle with their local service customers will be greater than ever. The LECs are facing the scary prospect—well known to firms in the competitive sector of the economy—that their financial success may not be guaranteed. Captive local service customers are their only remaining hope of retaining the financial security to which they have become accustomed.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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The linchpin of the LECs' efforts to shelter themselves from competition is the following familiar assertion: basic exchange service is priced way below cost and subsidized by the services that are now being opened to competition. Those subsidies may have served valuable purposes in the past, the argument goes, but they cannot be sustained if the LECs are to have a fair opportunity to compete in the sectors thrown open to competition.

The beauty of this argument from the LECs' perspective is that it completely exonerates them from any responsibility (such as the possibility of inflated costs) for rates that are not competitive. And it enables the LECs to argue that rate reductions for the newly competitive services should be offset by rate increases to the supposedly below-cost basic exchange services.

This argument that basic services are receiving a large subsidy is being used to justify billions of dollars of monopoly rate increases, a large portion of which have already occurred. Since such large sums of money are at stake, it is more vital than ever that regulators closely examine the validity of the subsidy claim.

Some may be surprised at my suggestion that there is a dispute about whether basic exchange service is receiving a subsidy. I chalk that up to the telephone companies' masterful domination of the public discourse, certainly not to any factual demonstration that basic service is being subsidized. Solely through decades of constant, unflagging repetition in every forum and at every opportunity, the telephone companies have managed to transform an unproven assertion into an unassailable fact.

TURN had the opportunity to examine this "fact" in California's intra-local access and transport area competition and "rate rebalancing" case involving our two largest LECs, Pacific Bell (PacBell) and GTE of California (GTEC).3 The only way PacBell and GTEC could support their claim that basic residential service was subsidized was by allocating all of the fixed costs of the local exchange network to basic service. Of the total reported costs of basic service of about $25 per month, those fixed costs made up about 80 percent.

The problem with allocating all of these costs to local service is that the local exchange network is designed for and used by all telephone services—including toll and enhanced services—not just local service. The fixed network costs are joint and common costs incurred to provide a variety of services. Assigning all of those costs to basic service is about as fair and economically efficient as assigning all of the companies' executive salaries solely to basic service.

What we discovered in our recent case was that PacBell's $8.35 rate for basic service more than covers the directly assignable costs of basic service. The difficult question for regulators is how to allocate the huge pot of joint and common costs that are not clearly attributable to just one service. There is no obvious right way to do it.

Here is a simple example. Suppose that the cost study for a stand-alone toll network (i.e., a network that included all the elements necessary for toll calling and only toll calling, such as the local loop and switching facilities as they would be designed solely to provide toll service) showed that the local loop portion of such a network would cost an LEC 150 units. Suppose that the local loop in a stand-alone local exchange network would cost 100 units. This would mean that the toll network causes 50 percent more of the local loop costs than local exchange service. In this case the allocation of the joint and common local loop costs should ensure that toll service is assigned 50 percent more of those costs than basic exchange service.4 But when phone companies report as fact that basic residential service costs $25 a month (a figure that includes all the fixed network costs), they are at best being misleading. In reality, their cost numbers rely on a lot of highly controversial assumptions, arguments, and economic theories.5

Regulators have to grapple with this issue if they want to protect monopoly customers from becoming the guarantors of the LECs' success in competition. They need to be skeptical. Many California regulators did not even know there was any controversy about the cost of basic service; they had been so thoroughly indoctrinated by the phone companies' party line. Regulators need to get their hands dirty by requiring and critically examining studies of the cost of major services and then deciding the fair amount of costs to recover from basic exchange services and how much of the fixed network costs should be allocated to other services.

Once the fair amount of costs to recover from basic service is determined, rates should be set to recover those costs, no more, no less. Once it is clear that basic service is no longer receiving a subsidy, the LECs will not be able to argue for increased basic rates every time a former monopoly service is opened to competition. The idea is to build a wall around basic exchange service rates and make it clear that those rates are not available to fund competition.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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RATEPAYERS AS INVOLUNTARY INVESTORS

The second major challenge for regulators I want to discuss is that of resisting the pressure from LECs to make ratepayers involuntary investors in the advanced telecommunications networks that the LECs are now building. In California we are hearing a steady refrain from the LECs that they need rate relief to accelerate the development of the telecommunications infrastructure.

Raising rates (or, just as bad, not decreasing rates as much as would otherwise be justified) to pay for infrastructure is doubly unfair to ratepayers. First, it makes ratepayers fund and bear the risks of investment without offering any prospect of a return on the investment. In a competitive market, firms do not have the luxury of simply raising their prices to fund investment. They have two choices: use internal capital or raise new capital in the debt and equity markets. In either case, investors will demand and be entitled to a return on the investment.

Allowing LECs to collect inflated rates from ratepayers to fund infrastructure investment is like giving them free money. They will use that free money to build advanced broadband networks, which they will claim they, not the deep-pocket ratepayers, own. By virtue of their "ownership" of this new network plant, the LECs will argue that ratepayers are not entitled to any of the returns on the investment. If this argument succeeds, the LECs will have shifted all of the risk of the investment to ratepayers while denying them the return that investors in our market economy are entitled to. Ratepayers will put up some or all of the capital for the broadband networks and then be required to pay the LECs for the privilege of using those networks.6

Compounding that unfairness is the second problem: if rate increases to fund investment are allowed, the customers who will pay the excessive rates are for the most part not the customers who will be using and benefiting from the infrastructure they will pay for. The purpose of the new broadband investment is not to enhance basic voice service but to allow sophisticated new video and high-speed data services to come to market. (One obvious purpose is to make competitive forays into the cable television market.) Using inflated rates for basic voice-grade service to pay for advanced video and data transmission services is a classic and indefensible cross-subsidy.

The enhanced competition that has been a central goal of telecommunications policy for the last decade could be a casualty of such de facto ratepayer funding of broadband networks. Telecommunications firms that are operating in competitive markets do not have the luxury of charging inflated rates for monopoly service to finance their new investment. Lacking the unfair advantages of the LECs, they may be hamstrung in their efforts to mount a significant competitive threat.

If funding of infrastructure investment is left to the market, will that mean that certain groups of people or certain geographic pockets will not be served by new investment? The argument is made that, for these left-out sectors, ratepayer funding will be necessary to provide the advanced infrastructure.

Regulators need to examine these claims closely and skeptically. With free money available, the LECs have a strong incentive to claim that infrastructure investment is uneconomic in a given sector and will not happen without ratepayer funding. Before monopoly rates are used to fund any investment, the LECs should be required to prove that there is no possibility of using private capital for the investment. If the LEC can make this showing and the regulators authorize inflated rates to pay for the investment, then ratepayers should be treated the same as any other investors and receive their fair share of the returns.7 I suspect that if regulators made it clear that ratepayers would be entitled to returns on investments they are required to fund, many supposedly uneconomic investments would suddenly become economic.

Before raising rates to foster accelerated investment, regulators should do everything possible to prevent basic monopoly services from cross-subsidizing advanced competitive services. The fairest way for the LECs to recover their costs of providing advanced service is through the rates they charge for those advanced services.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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There may come a time when a service we now consider an advanced information age service becomes necessary for effective participation in society. 8 When that happens, under my definition, that service would be considered part of universal service. Groups that could not afford the full cost of the service would be entitled to discounts to make it affordable. The discounts should be broadly funded by a surcharge on all telecommunications services.

However, regulators should be skeptical of claims that we need a dramatic redefinition of universal service now to include emerging broadband services. The LECs and many manufacturers have a strong financial interest in a world of universal broadband, even if most of the population does not need it. Proclaiming access to sophisticated broadband-type services to be part of universal service ahead of any demonstrated strong need or demand would enhance revenues for many manufacturers and for telecommunications carriers, which would benefit from major new markets.

Lofty claims are being made that broadband services will revolutionize education, health care, and citizens' ability to participate in government. There are powerful interests that have a strong financial incentive to make these claims. Decades ago we were also told that television would be a powerful educational force and a vehicle for the expression of a broad diversity of ideas and voices. Television has turned out to be overwhelmingly an entertainment medium that offers precious little opportunity for underrepresented segments of society to get their voices heard. It is possible that, like television, broadband technologies will prove to be mostly a means for enhancing entertainment opportunities.

A more prudent approach to expanding universal service would be to wait to see which new services become essential and use Lifeline-type discounts as needed to make those services affordable for those who need financial assistance.

CONCLUSION

Some of the hard work that lies ahead for regulators could be obviated if LECs adopted a different approach. The hard work I have identified falls mainly into the category of protecting consumers against monopoly pricing. Many LECs claim to welcome fair and open competition. Unfortunately, in the regulatory trenches, they are demanding terms for the onset of competition that use their remaining monopoly customers as a crutch and that hamstring their competitors. I challenge the LECs to live up to their rhetoric and to resist the urge to continue to rely on ratepayers as a deep pocket funding source for their private investments.

When it comes to infrastructure development, consumers would be best served by regulation that promotes diverse choices of telecommunications companies and services. Managing infrastructure improvements should not be the endeavor that keeps regulators busy in the next decade.

ACKNOWLEDGMENT

I am indebted to TURN's telecommunications analyst, Regina Costa, for many of the ideas in this paper. Of course, I am responsible for any deficiencies in the analysis.

REFERENCE

Melody, William H. 1983. ''Diversification, Deregulation, and Increased Uncertainty in the Public Utility Industries," Proceedings of the Institute of Public Utilities, Thirteenth Annual Conference, MSU Public Utilities Papers. Institute of Public Utilities, East Lansing, Mich.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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NOTES

1.  

My wording of the universal service objective reflects my views about how the "service" part of universal service should be defined. It is not enough just to promote access to a dial-tone service. Today, the level of service that is essential to effective participation in society would include affordable calling (to businesses, schools, health care providers, etc.) within one's community of interest. The definition of universal service is fluid. It should evolve as our requirements of and expectations from telecommunications service change. Tuch-tone service is a good example. A few years ago touch-tone service was convenient but not necessary. Now many businesses, government offices, and health care providers require touch-tone to be able to take full advantage of their services. As a result, touch-tone should now be considered part of the service that should be universal.

2.  

The large portion of residential customers who use telecommunications services sparingly will not be an attractive target for competition for competition for many years to come, if ever.

3.  

California Public Utilities Commission Investigation (1.) 87-11-033, Phase III, the Implementation Rate Design (IRD) phase. As of May 1994, the California commission had not issued its final decision in this proceedings.

4.  

The method I have seen that would best replicate cost causation would make use of stand-alone cost studies of the various services that use the local loop. The joint and common costs of the local loop would be allocated among these services based on the extent to which each service causes local loop costs to be incurred, as shown by the stand-alone cost studies.

Here is a simple example. Suppose that the cost study for a stand-alone toll network (i.e., a network that included all the elements necessary for toll calling and only toll calling, such as the local loop and switching facilities as they would be designed solely to provide toll service) showed that the local loop portion of such a network would cost an LEC 150 units. Suppose that the local loop in a stand-alone local exchange network would cost 100 units. This would mean that the toll network causes 50 percent more of the local loop costs than local exchange service. In this case the allocation of the joint and common local loop costs should ensure that toll service is assigned 50 percent more of those costs than basic exchange service.

5.  

One of these theories is that nontraffic-sensitive costs (such as the costs of the local loop) should not be recovered through usage-based rates. This theory is based on a narrow view of economic efficiency. It ignores the ineffeciencies and inequities that result when services are not priced to recover the costs they cause. To use an example of current import, assume that a LEC builds a new broadband network that is needed only to carry video services but that incidentally can be used to provide basic voice telephone service. The above-described theory would hold that, if the video services are only priced on a usage basis, the nontraffic-sensitive costs of the broadband network should all be assigned to basic exchange service and recovered in the monthly service fee. The result would be that basic exchange voice telephone rates would would be used to recover broadband network costs that voice telephone service did not cause. The prices for voice and video services would be distorted, and many basic voice telephone cutomers would unfairly be forced to pay the costs of services they do not want. For an excellent discussion of the many issues surrounding allocation of joint and common costs, see Melody (1983).

6.  

Under this scenario, ratepayers would be equivalent to taxpayers being taxed to build the broadband networks that will be part of the "information superhighway"." The U.S. interstate highway system was built with taxpayer money, but at least those highways are publicly owned and taxpayers do not have to pay private owners for using what they have paid for.

7.  

This would be accomplished by determining the amount of the total new investment that is funded by ratepayers through rates that are higher than they otherwise would be. Based on a required annual accounting of the achieved percentage returns on the new investment, ratepayers would be entitled to that same percentage return on their investment. The ratepayers' returns would be flowed back to them in the form of reduced rates, targeting as nearly as possible the services whose rates had initially been inflated to finance the investment.

8.  

Determining when a service has become essential for effective participation will not be easy or free of controversy. This will a sociological judgment, not a judgment that will require the specialized technical expertize that regulatory commissions are supposed to have. Accordingly, decisions about expanding the definition of universal service (which will lead to higher surcharges—i.e., taxes) should certainly involve the legislative process.

The many important issues surrounding the potential expansion of the concept of universal service could certainly be the subject of a separate paper.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Costs and Cross-Subsidies in Telecommunications

Bridger M. Mitchell

One of the fundamental issues in telecommunications regulation is how to devise a method for sharing common costs. Some of the costs of the telecommunications system, including the entire range of services provided over the backbone network, are common to many users and services. The debate about how best to allocate the burden of paying these costs in ubiquitous in telecommunications regulation—and is frequently very confused, especially when the issue is whether a particular service or group of customers is being subsidized by other services and/or users.

As an economic matter, cross-subsidy among users and services is a well-defined concept. A group of customers is being subsidized if their price is so low that the service supplier and its other customers would be better off if the service were discontinued. This circumstance occurs only when the increase in revenues to the telephone company from offering the service is less than the increased costs of providing it.

Several years ago the California Public Utilities Commission collaborated with Pacific Bell, General Telephone of California, and the RAND Corporation to investigate the costs of providing local telephone service using current technologies. The objective was to construct a "building block" model of local telephone service, using data from California, that would estimate the best-practice costs of a local service system, using current technology, for communities of various sizes and other characteristics. In areas where no service was provided, such as a new housing development or industrial park, the model would estimate the total cost of a new local network. In areas in which a backbone network was already in place, the model could be used to estimate the cost of adding more subscribers or more usage by existing subscribers.

Several important findings emerged from this study (Mitchell, 1990), all of which are important in the debate about pricing policy and subsidization within the telecommunications system.

The first important finding was that almost all of the additional costs arising from either more subscribers or additional usage are fixed on a per-subscriber basis. Increases in variable costs arise only from additional usage that occurs at peak periods, which in turn gives rise to a need to increase busy-hour capacity in order to retain service quality. The importance of this finding is that usage-based pricing—such as a charge for each call or each minute of use—would not contribute much to the efficiency of the usage of the telephone system. Indeed, taking into account the additional costs of measuring usage and billing for it, the U.S. system of flat-rate monthly charges for residential local telephone service, including both access and calling, is probably not inefficient.

The second important finding of the California study is that by far the most important factor in causing variation across localities in the cost of service is the distance of the subscriber from the local switching center or, to put it another way, the length of the copper wire connecting the customer to the local switch. The distance of this connection is determined primarily by population

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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density, with customers in small towns and rural areas having, on average, much longer connection distances than customers in large cities.

This finding, too, has considerable policy significance. Local telephone prices are typically based on the average cost of service for all customers within a state or served by a single company with a broad heterogeneous service territory. The practice of rate averaging is extremely important because it discourages entry by local access providers that would deploy less expensive technologies for providing service with a long connection distances. For example, recent advances in radio telephone systems, such as the transmission systems used by cellular telephone companies, can provide high-quality local access in many low-density communities at significantly lower costs than the traditional wire-based telephone system.

The third major finding of the California study is that the incremental cost of service is much lower than the average cost of service. That is, adding more subscribers and more usage to an existing system is much less expensive, per additional subscriber, than the average cost per subscriber of constructing a completely new system. Thus, on a statewide basis, the average cost of service in California is about $25, whereas the incremental cost of service in most areas is less than half that amount.

An important implication of this finding is that in most areas local residential service, using present telephone technology, is a natural monopoly. Of course, this conclusion needs to be strongly qualified: it does not apply to central business districts of large cities with numerous businesses that are intensive users of services, to customer groups that seek technical capabilities going substantially beyond the features of the existing network, or to groups that are most efficiently served by radio telephone services, which do not exhibit extensive scale economies. Nevertheless, most residential subscribers do not fall into any of these categories.

All of these findings also shed light on the cross-subsidy issue. They suggest that more intensive users are not being significantly subsidized by less intensive users since nearly all costs are independent of usage. These findings also suggest that most residential customers are not being subsidized, in part because most residential customers do not live in areas with long wire connections to the local switch and in part because the incremental cost of serving one more residential customer in a local area is much lower than the average cost of service. For the most part, subsidies of local service go to residents of high-cost communities with low population densities: rural areas, small towns, and suburban communities with single-unit dwellings on very large lots. And, because in some cases these communities could be served at lower cost by other technologies, even here some of the subsidy is unnecessary.

A common argument for preservation of the existing structure of the telecommunications industry and system of regulation is that it is necessary to preserve universal service because it provides a means for cross-subsidizing users who would otherwise be unable to afford service. The California study casts considerable doubt on this argument. Most users are not cross-subsidized, which means that telephone companies would be worse off if they decided not to serve most customers at current prices. Many customers who are subsidized—notably, farmers, owners of rural second homes, and residents of low-density suburbs-could easily afford unsubsidized service.

REFERENCE

Mitchell, Bridger M. 1990. Incremental Costs of Telephone Access and Local Use, R-3909-ICTF. RAND Corporation, Santa Monica, Calif.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Economic Ramifications of the Need for Universal Telecommunications Service

Eli Noam

Among U.S. states, New York has been a leader in promoting competition among firms providing local telephone service. But liberalization does not mean instant deregulation. There is still a messy transition phase to go through, especially on the details of interconnection. The question is, does liberalization of telecommunications mean libertarianism, with no governmental regulatory role? And beyond, if there is free entry into all sectors of telecommunications, what will happen?

It is useful to conceptualize telecommunications networks as shown in Figure 4A. Network size is presented on the horizontal axis. The vertical axis indicates the cost of services provided and their utility to the consumer in terms of dollars. Two curves are shown. One is the average cost curve, and one is the benefit, or utility, curve. The average cost curve implies that a network is, in effect, a cost-sharing arrangement, with the burden of cost collectively assumed by users. Networks have a fairly significant fixed cost. As more users join the network the fixed cost is spread evenly over the various users, and the average cost decreases. But, as the network expands, higher-marginal-cost users join the network and the average cost starts to increase. The result is a U-shaped curve for most cost-functions. The curve for participating in the network increases with the number of people on the network. This is due to the positive externalities of network usage. These externalities tend to flatten out as the network reaches a certain size.

There are a number of distinct regions on Figure 4A. Prior to the point where the two curves intersect, cost is higher that utility. Therefore, somebody—either government or private investors expecting a future return—will have to subsidize the network. Beyond the intersection point, there is a region of self-sustaining growth. Beyond the point where the distance between the two curves is at a maximum, there is a range in which the network, left to the decision process of the users, would not grow, because costs are going up faster than utility and thus the net benefits decrease. Eventually, net benefits become negative when the curves again intersect.

This suggests that there are three areas where there will be problems (Figure 4B). We start with the first region on the left, where there is a critical mass problem. In the early stages of a network arrangement, funds for investment must be garnered because the cost of the system is higher than the benefits returned. In the traditional regime, this investment was done by the network monopolist itself. France Telecom, for example, put ample sums of money into Minitel, even giving away the terminals to its customers. Why? Because eventually the combined critical mass of users would be sufficient for everybody to benefit from the network, including its owner, France Telecom.

But, if that is a reasonable approach for a monopoly, it often will not work in a competitive environment because of the possibility of interconnection. A rival company can interconnect with a company's network and benefit from its rival's accumulated critical mass of customers without having made the up-front investments itself.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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FIGURE 4A Cost and benefits in relation to increasing availability of telecommunications services. P=AC, price = average cost; U(n), utility as a function of the number of users.

FIGURE 4B Three issues basic to provision of telecommunications services.

Thus, the economic incentives can be in favor of being the second, not the first, entrant. There will be less early investment, and some of the funds necessary to create a critical mass of users might have to come from outside. In Washington and elsewhere, this is an approach technologists are advocating. Many would like to see an injection of government money to deal with the critical mass problem.

But subsidies are not the only alternative. There are essentially three ways to deal with the critical mass problem. One approach for the government is to do nothing and let markets function independently. The second approach is to deal with the cost curve by reducing the initial cost of supplying the service. A final strategy involves demand-side policy, which implies increasing the utility curve by enhancing the value of the fixed services.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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The National Science Foundation, by supporting the "industrial policy" approach in the Internet, has both increased demand and reduced cost. Typically, in the United States and elsewhere, the approach has been to concentrate on developing the supply side of the graph (Figure 4A)—for example, by aiding the carriers that would do the upgrading. The alternative, supporting users at the demand side and thus reaching a critical mass, can be done by partly supporting leading-edge, technology-driven uses and also community-based applications. This is where the libraries and schools come in; they do not use leading-edge-technology, supply-side applications but rather demand-side, low-sophistication applications.

The second problem is indicated on the far right of Figure 4A,B, and it concerns universal service. Here the problem is that, because of competition, the network cannot maintain an internal subsidization scheme as in the past with some users subsidizing other users. When entry is free, the new competitors first target the users presenting the largest potential profits, and eventually the support system vanishes. To prevent such a collapse, a very elaborate system of access charges has been established. It is a system that is so opaque that hardly anyone can understand its workings. But in a democratic society there should be accountability, with an understanding about who is paying whom and how much.

There is a relationship between the critical mass and universal service problems. We will never get to the latter without having solved the former. However, it will be harder and will take longer for critical mass to be created unless there is also a willingness to deal with the universal service issue. Consider the Burns-Dole-Gore bill of a few years ago. In essence it said that in order for the government to aid (i.e., to support) by regulation the upgrade of the telecommunications network from copper-wire to fiber (the creation of a critical mass issue), it would also have to ensure that the rural United States would not be left behind (the universal service problem). In other words, it is not realistic to assume that Congress will pour money into the first problem without having some assurances that the universal service side of the network will also be taken care of.

The universal service issue is not going to go away. Some are convinced that competition will take care of any problems that arise. However, they are confused about the difference between allocation distribution and production efficiencies. Competition will increase production efficiencies. It will not, however, resolve issues of distribution. The fact that food growing and processing are competitive and efficient does not respond to the question of how to feed the poor. Even though it is possible to reduce marginal cost and the absolute number of people not served by market forces acting alone, the universal service issue is not fully addressed that way. There are positive externalities to adding to the network, as depicted by the upward-sloping curve in Figure 4A.

One alternative funding mechanism for universal service is a system that charges all carriers in proportion to their net transmission revenues and credits them for already existing contributions to universal service. The money would go to categories of customers designated by the political system. They would get vouchers for their subsidies and be able to select their own carrier. Competition for such customers would force the carriers to be efficient. Carriers serving low-density areas could also be benefited, although not on an exclusive basis.

A further problem is represented by the middle range of Figure 4A,B. A competitive environment for telecommunications involves a complex arrangement of carriers providing services for different segments of the market: local, mobile, long distance, and international, in addition to vendors of hardware and software. In such a complex carrier system, specialized "systems integrators" will invariably emerge to put together packages of services. This is already happening today for large customers, and will most likely be available to smaller customers in the future. A restructuring plan by the Rochester Telephone Company is going in this direction by separating the service function from the network carrier function.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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These systems integrators will effectively undercut the underlying carriers. The basic economic reason is that in a competitive market, the integrators get the services and can resell them at marginal cost, while the carrier has to bear the full cost per unit, including an allocation of fixed costs. Since in network industries with large economies of scale the marginal cost will be below the average cost, the integrator will economically outperform the carrier providing the underlying service. Several things will therefore happen.

One is that the whole notion of common carriage, which is based on similar conditions of service for similarly situated customers, will break down because the common carrier cannot compete against a systems integrator or contract carrier that can price-differentiate and select customers. Secondly, to the extent that the common carrier cannot recover its full cost, there will be underinvestment in the network infrastructure itself. In the future, policymakers will have to deal with the question of how the network system can maintain its financing in a situation like this.

In a competitive environment of carriers, systems integrators make unnecessary many of today's regulatory interventions. For example, price regulation becomes largely irrelevant because systems integrators will shop for the best deal for their customers and will compete among themselves for those customers. But what is not going to go away under competition is the universal service issue, and the common carrier (open access) issues. Interconnection problems are also likely to remain in this environment.

The final question is how to reform the existing regulatory system to deal with future issues. Although many people believe that state regulators are part of the problem, it is important to recognize that the decentralized reform process has worked reasonably well in the United States. The Japanese, French, and Germans, all of whom have a centralized decision-making process, have taken decades to reach what a decentralized system has accomplished much faster. Regulatory reform in the United States might not be a logical progression based on a national blueprint, but in most other places these blueprints have taken long to draft and are invariably timid. The United States, using a decentralized mechanism, has been able to reform its telecommunications system quite well. Those who believe that a decentralized Adam Smith-type mechanism is working well in decision making in the sphere of economics should not reject out of hand the same mechanism for decentralized decision making in the political sphere.

In conclusion, liberalization of telecommunications does not mean libertarianism. Many regulatory issues will go away, but others will persist in new forms and new ones will emerge, as discussed. For better or worse, government will not vanish from this sector; the challenge is to orient it toward an open future.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Discussion

BRIAN KAHIN: I want to pick up on Nina Cornell's concerns about interconnection and the issue of the government's role. It is worth bringing up because it is very often overlooked. It is not even mentioned in the administration's information infrastructure document. The NSF [National Science Foundation] is involved in the program to restructure the NSFNET, which is in effect unbundling the NSFNET as it exists today so that NSF is no longer providing a single package in its main contract but has broken out the different roles of routing arbiter, a very high speed backbone that will be very restricted in use, and the newly conceptualized NAP [network access point].

In principle the NAP is an exchange or switch where anybody can interconnect, and it is a way to get onto the very high speed backbone if you have the right to do that. It is not clear how many NAPs there are going to be. NSF is going to fund them, and so we have the government funding something that is not subject to an acceptable use policy but that is general-purpose infrastructure investment.

To what extent will this architecture catalyze the larger infrastructure? How will the commercial Internet crystallize around this concept? I wonder if we are seeing an inversion of the paradigm from the network as a carrier to the switch as a carrier and what that means for understanding the cost-price differential, because it seems to me it is a lot easier to get at that when the carrier is as simple as a switch. That is not going to solve the "last-mile" problem, but it might be progress.

ROBERT CRANDALL: I still have some difficulty with imagining what the network or networks of the future are going to look like. I do not see any reason why there is one network, given what we know about what is happening to transmission switching costs. I can imagine lots of different networks into which I could connect with a piece of terminal equipment that has a set of switches that can connect me to lots of different networks and lots of different nodes.

One of the problems of this discussion is that it is based on what we know is the current network, the current public switched network developed under regulation. One of the things we know about other industries is that once we deregulate, the technology changes and market organizations change in ways we could not possibly predict. In fact, it may be that regulation is condemning us to one particular model that is incredibly inefficient.

KAHIN: Also, the network that we have been focused on is a homogeneous network, whereas now, especially in the Internet, we are entering an environment of heterogeneous networks, where the networks all differ in capability and functionality and speed.

CRANDALL: That is right, but there could be a bunch of different backbones, too, not only a bunch of different LANs [local area networks].

ALFRED AHO: This panel spoke of some of the experiences learned from regulation in Japan. In the United Kingdom, there is ongoing competition between the telephone companies and

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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the cable companies. Are there any lessons that we can learn from regulation in the United Kingdom?

CRANDALL: I do not know much about what has happened with cable versus telco competition, but they have admitted that going from one carrier to two carriers—but making sure there was not a third, fourth, fifth, or sixth carrier—was a mistake, that a duopoly was not much better than a monopoly if it was protected by regulators from entry.

ROGER NOLL: In the United Kingdom the regulatory system itself has not led to competition of the form that we think of in most of the U.S. system. It has led to a somewhat better but nonetheless regulated system whose prices are somewhat better than they were but are not as low as ours. Bob, do you want to talk about that?

ROBERT HARRIS: Yes, just very briefly. The joint offering of telephony and cable entertainment services in the United Kingdom is very different because they basically did not have a cable system. The cable system being deployed was originally designed and engineered to provide both telephony and video and hence does not have a lot of the problems that Dale Hatfield talked about that the U.S. cable system has. It does suggest, however, that as we modernize cable plants in the United States, they can perhaps be reengineered if enough cable operators get the idea that there may be a market for telephonic-type services. But in comparing a de novo situation in Britain to an existing cable plant in the United States, I think you had better be very careful about any kind of lessons you draw from one to the other.

NOLL: I think the main lesson Americans have tried to draw from the United Kingdom concerns how they regulate prices, and there are two lessons to draw on. The first is that they have price regulation; that is to say, all prices taken together, indexed, are capped by the rate of inflation minus 3 percent. It turns out that that system has demonstrated two important principles. The first is that the rate of technological change and advances in productivity inside British Telecom substantially exceeded historical experience, and the second is that the politics of the system requires that they change the rule to make prices fall even faster. That is to say, the second important lesson is that the notion that you can have price regulation that leads to better price performance but enormous profits of the regulated utility is obviously incorrect on the basis of the experience in Britain.

COLIN CROOK: One interesting early indication in the United Kingdom in the cable area is that when the cable companies had basic telephony on the cable system, the turnover on the cable side went down to essentially zero. People will not disconnect their telephones like they will disconnect their cable systems, so some very interesting business is going to be lining up when we start to merge these areas together, I would forecast.

GEORGE GILDER: Two questions. First, it seems to me that digital wireless technology is going to destroy that differential between the cost of rural and urban service almost entirely, and I wonder what Dale Hatfield, for example, thinks about that prospect and what its effect will be.

Second, it seems to me that the price of nodes drops about 50 percent every 18 months and that they just multiply increasingly and that nodes are no longer a bottleneck. Nodes are dropping radically in price and moving rapidly to the fringes of all the networks, so the nodes are really in the command of all the users rather than in the command of the transport people, and I wonder how this process is going to affect the vision of the node as a bottleneck that allows monopoly power to be exercised.

DALE HATFIELD: Let me comment first on wireless. I think that there are some very attractive possibilities with wireless, so I think you are absolutely on the right track. However, you are still faced with most of those other issues I talked about, the terms and conditions of interconnection with the existing carrier and so forth. Also, there are probably some bandwidth issues, perhaps obviously less in rural areas, but to the extent that we are getting more bandwidth-intensive applications, even fairly generous spectrum allocations tend to look not quite so generous, and then I would also say it is not clear to me how all this will sort out.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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At one time, I looked on cellular as perhaps having some prospects, but it ended up being in relatively concentrated hands. With the spectrum that the [Federal Communications] Commission has now set aside for PCSs [personal communication systems], it is not clear to me who is going to end up winning that spectrum, and it is not clear to me that we will even then have a fully competitive marketplace. Generally the conclusions that I had before, which I could summarize by saying I am uncertain, still hold: I am still uncertain, even with the prospects of wireless, for those reasons.

NINA CORNELL: I think there is one thing that is not well recognized. Radio may help with the rural-urban distinction, assuming you solve the bandwidth problems and the concentration problems. But to serve a location like the one where I live, you are talking about having to put in a number of radio transmitters to serve essentially 10 households, and so you are still going to have a very high cost per household because there is very little sharing of a particular set of technology. So you are still going to have that same phenomenon of, if you pardon the expression, "diseconomies of scale" for rural, because even though there are a few lovely places, probably in South Dakota and Nebraska, where they can go long hops and not meet mountains and convoluted terrain, a lot of the most sparsely populated areas happen to be in the mountains.

The second thing about nodes is that it is not that the price or cost of nodes is so high; it is literally that they are—despite price, despite cost—a bottleneck because you have to get from the node to the end user. It is that link, if you will, and its connection at the node, that has been used so successfully—and continues to be able to be used so successfully—to control the system if there is not some regulatory control in the broad sense over how it is used and what the prices are. Even if I had continued to live in downtown Washington, I would not have the ability to call up and say, "Please connect my local loop to somebody else's node tomorrow. I have changed my mind."

VINTON CERF: There are a number of reasons for regulating. The obvious one that comes up is abuse of monopoly power, but let me ask you, Nina, whether you sense other reasons for regulating, especially in this new information infrastructure environment, other than to avoid abuse of monopoly. Is there a public interest, a public good that needs to be protected, which is not necessarily subject to abuse by monopoly power?

CORNELL: That is a tough one. I sit wrestling in a very personal way with the whole issue of rural telecommunications. Those of you who know me know that I live 20 miles outside of a town that has 362 people and the nearest city of any size is at least a three-hour drive away. I happen to believe it would be a very bad idea to see rural America disconnected from the network, and I am concerned about that. At the same time I can tell you that having looked up close and personally at the "subsidy" mechanisms, and having discovered that their present value is about to be handed to US West as a gift as they walk away, I am not very convinced that we are doing a very good job of it. Maybe it would be better if entry were permitted.

I would love it if somebody wanted to do a voucher system so that it is not capitalized and given away, but I do not know the real answers to that. I am concerned about Eli Noam's third bubble, the universal service one [Figure 4A,B], because I am concerned about disconnecting—not me but everybody in the community around me—from the entire national network, which is, in fact, a real threat at the moment.

GEORGE TURIN: I need some help here. Let me start with a disclaimer. I am not now, nor have I ever been, an economist, so I really need some help. Everything I have heard from this panel, even from those who defend some aspect of regulation, seems to be in the direction that regulation will stop entities from doing things that they might do if the free market had total play, and those things that they might do might be bad, so regulation has some role. That seems a very reactive statement about regulation.

On the other hand, we heard in the first session this morning from several user communities, three out of four of which are going to need some real help. Now, here is where I need some help myself. Tomorrow's session concerns government investment. Is positive government investment

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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the only way that those user communities are going to get help? Is there no way that regulation per se can act as a proactive force to help user communities that may be disenfranchised in some way—such as the library, education, and health care communities?

NOLL: Who would like to speak for using regulation to help health care?

CORNELL: Some of the kinds of concerns raised this morning were flat-out government: government pays for education, textbooks, and school buildings, and if pipes to the Internet are important, government should pay for that. But in the drive to price everything in telecommunications usage-sensitively versus flat rate is an issue that has some major implications, I think, for education, health care, and libraries. In that regard, there are some interests and some questions, and I do not think these are issues of subsidies. I was encouraged when Bridger Mitchell said he was not certain that flat-rate pricing was inefficient, because like one of the blind people trying to identify an elephant from a particular peculiar piece, I see measured usage often being used as a way to try to curb entry and to create barriers to use rather than being really efficient. I think there are some issues regarding flat-rate versus usage-sensitive pricing, particularly at the local level. It is a peculiar situation, particularly in the case of education and public libraries. We do view those as things we fund publicly, and so the issue is not really subsidy. The issue is funding, but I think, as I said, there is a different issue in regulation there.

CRANDALL: I do not know anything about libraries, but if you think about public education and the health care sector, you think of two institutions in our society that are starved for funds. I think what is wrong there is the incentive systems—there is no incentive to be efficient or to adapt to the right technology. I do not see any reason why government subsidies for infrastructure would improve their performance in any way.

NOLL: I agree, but in a certain sense the issue still is the reason that the educational system or the library system would choose to allocate as it has all of its previous budget increases. Recently there have been vast reductions in budgets for libraries, but the elementary and secondary education system budget has been growing in real terms for most of the post-war period but has by choice not been invested in telecommunications.

Now, the explanation for that could be, as Eli Noam put it, a critical mass problem. But it is hard to imagine a state the size of California or New York having a critical mass problem. In California, the state educational budget is determined by the state legislature. The funding is all centralized, and the state could in fact take 3 or 4 percent of the educational budget and invest it in telecommunications for educational systems, but it has chosen not to.

I think that before you get to George Turin's issue, you have to identify exactly why telecommunications hasn't been invested in for education and what the problem is for which we are trying to find a solution. In principle that is an enormous public-sector activity that does not choose to buy textbooks, let alone to invest in telecommunications. It chooses to do other things, and if the world is such that the politics of education selects against the delivery of information to students in favor of something else, it is exactly the same politics that will drive a regulatory institution. They are not separate. They are run by the same state legislature and governor. So what is it that regulation can solve that the state-centered budgeting of education cannot solve?

TURIN: So in short form, the answer is no.

NOLL: Yes.

LAURA BREEDEN: I am the executive director of FARNET, which is an association of Internet service providers. I am neither an economist nor a political scientist, but I did have to do this for a long time using some government money and some money that we got from clients, so I have a certain practical feel for these issues. I do not know what the right answer is in terms of regulation, but I can tell you that when you sit down to do your business plan or your budget for the year, what you are looking at is a huge expenditure on lines.

The cost of those lines for the long-haul sections has gone down and down. In fact, it does not much matter whether you are calling from Boston to Syracuse or Boston to San Francisco; it is

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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still 22, 23, 24 cents a minute. The real cost is in the local loop facilities, which have not been deregulated. So when I hear someone ask if regulation is going to make a difference, I look at long distance and say, ''Has regulation made a difference in the price of service?" I am one of the systems integrators. The world that I come from is the world of the systems integrator, where you buy the raw material, in this case the transport, from the phone company or from the bypass vendor and then you add value, the routers and Internet service, and so forth. So can regulation help? Deregulation can help. Deregulation might bring the cost of the local loop down so that you are not looking at $37,000 for an Internet connection, $20,000 of which is in the local loop, which is an artificially high cost. Maybe deregulation is a form of regulation. Maybe that is the answer.

NOLL: I am going to add one more item to the program and then we will go to discussion from the floor. Notice it was mentioned by both Tom Long and Eli Noam in their discussions that an important element of policymaking is to figure out what the costs are, not only of the existing system but also of alternatives. To my knowledge by far the most comprehensive and best study of the costs of the telecommunications system under the current technology was performed by a group at the Rand Corporation led by Bridger Mitchell, so I have asked Bridger to tell us briefly the basic story of that study.

BRIDGER MITCHELL: I think Tom Long really raised one of the key questions by saying one of the fundamental issues is how to share a common cost, a cost that the telecommunications must incur in order to provide a whole range of services. Much of the debate in the regulatory commissions and the policy community has been confused; it has been about allocating that common cost among one or the other or several services. But the correct question in terms of a pure cross-subsidy is whether the prices are so low that the firm and the remainder of its customers would be better off by not supplying a particular group or a particular service. If the firm's actual net costs would go down or its net profit would go up by getting rid of the service, getting rid of the set of consumers, then that would be a cross-subsidy.

Several years ago, the California Public Utilities Commission joined forces with Pacific Bell and GTE in California and Rand to actually look at the technologies for delivering current-generation access and local exchange service. They put together a building block model, as it were, of the technology that is in use there and pretty much throughout the country and using data from California. Now, what came out of this? We were looking at the cost of adding subscribers to the existing network where the telephone system was already operating or adding additional usage by subscribers who were already on the network. And the basic findings that I would summarize here are that most of the costs of additional use or additional subscribers are fixed on a per-subscriber basis when one is looking at access to the network and use in the immediate local environment.

The variable costs that come out are primarily driven by the need to have additional capacity for peak or busy-hour utilization in order to provide and maintain quality of service. So one consequence of that is that flat-rate service for local calling, immediate local areas, does not look terribly inefficient when most of the costs of additional usage are primarily driven by peak-hour capacity. Another basic finding in that study is that the variation in costs across the state are driven primarily by the distance of the subscriber from the local switching center or the local wire center, and so rate averaging is discouraging entry in the high-cost, predominantly rural or suburban communities.

Finally, incremental cost, which is really the numbers we were looking at, is substantially below the average cost of the total plant if you were to build the local exchange from the ground up. That would suggest that on a statewide average, incremental costs are considerably below the $25-per-subscriber-per-month number that was being used in these filings.

NOLL: Just to put an important point on it, if you ask what is really subsidized, the bottom-line answer is, telephone services in small communities and rural areas, from the point of view of what the economist defines as a subsidy (which is actually paying less than the incremental cost of the service provided). So the really important point here regarding the debate about pricing

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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and cost allocation is that there is a hunk of costs arising from the sort of economies of scale in the local telecommunications system and there is a fixed cost, so that the regulatory process becomes the mechanism whereby people fight out that battle in a legalistic and political sense about who is going to bear what cost. The outcome is that it is not the case that large numbers of people end up with subsidies.

It is the case that rural areas and small towns end up with subsidies, but everybody else is basically paying more than their incremental cost. There are economics we could then bring to bear concerning how you divide up that fixed cost most efficiently, but the problem is not really lots and lots of people getting subsidies. The problem is the fundamental conflict that was represented in the session between the technical and economic features of the industry to begin with and the political determination of how the cost of the system will be borne.

CHARLES JACKSON: Mr. Long, you stated, if I recall correctly, that the cost of the local loop should not be allocated just to basic service, and we have heard people talk about unbundling. Several questions here were about unbundling.

I live in Maryland. In Maryland a company called MFSI has applied to offer competitive local exchange service, at least in Maryland, to business and government. I will quote from one of their filings: "MFSI proposes that C&P [the local exchange carrier] be required to allocate the costs of providing dial-tone lines between two fundamental functions, links and ports, and to tariff separate unbundled rate elements for links and ports."

My first question, as a consumer advocate, is whether Maryland should approve or deny MFSI's request for such unbundling, and if they do unbundle, with or without your approval, whether all the cost of loops should be allocated to links and whether C&P should be allowed to geographically de-average link costs or should be required to maintain some sort of statewide average pricing of these things facing business or competitors?

THOMAS LONG: You will have to excuse me. I am not quite sure what MFSI meant.

NOLL: The idea being that somebody could get into the business of taking the C&P copper-wire loops but then connecting them to their own switch instead of the C&P switch. Or the alternative option.

LONG: I am afraid you have stumped me for now. I want to think about it.

HATFIELD: I would just add an anecdote. If you go back in the course of early history that we talked about, you find there were far more lines in the United States. One of the reasons we had rapid roll-out of telephone service is in part because farmers constructed their own lines and connected them to an existing switch in town. In this discussion, we have done a 360. We are back to the idea that maybe farmers should be able to construct their own lines and connect to an existing switch.

NOLL: I think the question about de-averaging is really crucial, because it not only is the loops versus ports story, it is that within the same town, some people are going to be 100 yards from their first switch and some are going to be 5 miles. Concerning Bob's point about the network architecture being not necessarily the most efficient, the only way to find out if the current arrangement is the most efficient is to have a relatively small number of very large switches in cities with lots of people connected a long way away from them, and then to charge the people who are 5 miles away ten times as much for telephone service as the people who are 100 yards away.

HARRIS: But by that, you do not necessarily mean they pay that out of their own pocket—have them face the price and decide?

NOLL: That is precisely the point. The reason it is a test is because the people who live 5 miles away and who face $100 a month for a telephone bill, right now in the current environment would have a very, very strong incentive to go for a cellular telephone instead because it would be cheaper.

WALTER BAER: Bob Harris spoke eloquently about the need for some federal preemption of state regulation. I would be interested in how the other panelists would comment on that,

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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particularly regarding competitive entry. Also for Eli Noam's scheme: Eli, can that be implemented on a state-by-state basis, or does that require federal rules in implementation?

ELI NOAM: It would require federal principles and state implementation, which I think is basically the way federalism in the United States should function in the future or to some extent functions today. If you have redistributive systems or support systems on a state-by-state basis, presumably you would have some kind of a race-to-the-bottom competition among jurisdictions and all kinds of manipulations by carriers to shift costs and revenues. At the same time, if you had it totally centralized, you would have early implementation problems or you would not let New York or Wyoming go their different ways. So I think within the principles of federally set principles, you can permit local variations.

NOLL: Eli, address the following problem. I think this is the thrust of Walter Baer's question. Suppose the FCC takes the position that for state regulators that adopt the following state regulatory rules we will allow reintegration of the Bell operating companies. How would that work out exactly? Would you imagine that all 51 jurisdictions would adopt basically the same regulatory system for the local loop?

NOAM: I do not think they would. It is not clear to me whether they should. Take local competition. I think some of the states, New York and Illinois, for example, have been at the forefront of it and in a way have provided some of the models that have been implemented on the federal level either by the FCC or by a federal jurisdiction right now. That is, in a way, the way the system should work. You have a kind of basis for experimentation in the states, and if I were to fault the states it would actually be for not being innovative enough, for not using more of the competitive ability to be flexible and to have variations but rather congregating around generic kinds of resolutions to lowest-common-denominator policies. That is really the problem, not state experimentation.

Now, after a certain period for states to experiment, you can imagine a system in which the FCC or some other federal body will make this nationwide as long as you do not cut off the flexibility. I think it would be a real mistake.

CERF: It seems to me that one of the things that gets in the way of effective competition is lack of continuous competition. There are a lot of examples where you do not get this opportunity—in the cable companies, for example, since it is a franchise arrangement. If there is any competition at all, it is at the beginning of the franchise and then there is some period of time before which there might be any other competition. Some of the government telecommunication system services are like that. FTS-2000 is an example of an intermittent competition, it seems to me. (If I get this all wrong, the economists will fix me up, I am sure.)

But is there any way for us to assure that, as we enter into this new information infrastructure age, we are able to inject an opportunity for continuous competition so that consumers can change their minds and move from one supplier to another regularly? The first question is, Is that any good, is that useful, is that a helpful mechanism? and the second is, Is there anything getting in the way of doing that?

NOAM: It is a big question, but I would say the one way to deal with this is to make possible competitive entry that is less than end to end, for example, so that would mean a certain amount of unbundling of services for the telephone industry. In the context of the cable industry, it would mean the unbundling of the set-top converter-box-type technology from the network provision and a whole range of intermediate access issues so that entry can be partial rather than full. That is only a partial answer to your question.

CHARLES OLIVER: Eli Noam made the assertion that telecommunications is not price elastic and therefore it was okay to impose subsidy burdens on it. Does anyone else agree with that as a global assertion? Certainly we have seen the demand for access to interstate long-distance service more than double since the subscriber line charge was phased down. The implication is that

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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basic local service is what should be bearing the subsidy burden and it should be cross-subsidizing long-distance service.

NOLL: Well, to defend Eli, he was not attempting to defend any particular cross-subsidization. What he was saying is that if a "philosophy king" who also happened to be an economist descended upon the earth and decided he wanted to raise X dollars in tax revenue, what would he tax? The answer is he would tax only the most inelastic demanded things, and basic access to the telephone network is about as inelastic a demand item as there is. That is all he meant.

OLIVER: So by that logic, if you could, you would tax oxygen and food?

NOLL: No. It was discovered at the time of the Doomsday Book that the right way to tax people is proportional to the heads they have.

Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Suggested Citation:"PART 2--REGULATION AND THE EMERGING TELECOMMUNICATIONS INFRASTRUCTURE." National Research Council. 1995. The Changing Nature of Telecommunications/Information Infrastructure. Washington, DC: The National Academies Press. doi: 10.17226/4816.
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Advancement of telecommunications and information infrastructure occurs largely through private investment. The government affects the rate and direction of this progress through regulation and public investment. This book presents a range of positions and perspectives on those two classes of policy mechanism, providing a succinct analysis followed by papers prepared by experts in telecommunications policy and applications.

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