Introduction to universal service policies

The sum of an incumbent telephone company’s retail rates in the aggregate is mostly determined by the mechanics of rate-of-return or price cap regu-lation. But this calculation does not answer the question of which cate-gories of customers will end up paying what percentages of these costs.

One straightforward approach would be to estimate the cost of providing particular services, add a reasonable allocation of the regulated company’s

“joint and common costs,” such as the CEO’s salary, and use that number as the basis for setting rates for those particular services. But that is not generally what happens because, as public choice theory predicts (see chap-ter 1), telecommunications regulators are motivated by political objectives in addition to purely economic ones.

In particular, regulators have traditionally set rates for certain services, such as residential service in many areas, below the cost of providing them—although, to be sure, the precise measure of “cost” in this context, and the extent to which an incumbent local exchange carrier actually pro-vides service to residential customers “below cost,” have always been top-ics of debate. To cover the difference between these discounted rates and the actual cost of providing service, regulators have historically allowed the monopolist to set the rates for other services, such as those provided to business customers, above the cost of providing them. Theoretically, the regulated monopolist receiving these rates in the aggregate should be indif-ferent to such implicit cross-subsidiesbecause—so long as it faces no com-petition for the customers paying the above-cost rates—its books come out even in the end.

The term universal service is used somewhat overbroadly to describe the regulatory manipulation that produces low residential rates, even though such manipulation may be completely unnecessary to ensure that the beneficiaries actually remain hooked up to the network. Chapter 10 discusses the changing face of universal service in some detail, but it is important to cover the basics here at the outset.

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The telecommunications industry is riddled with different types of implicit cross-subsidies justified as necessary for “universal service.” If you live in a highly populated urban or suburban neighborhood, the odds are that you are paying the same basic rate for telephone service as someone living deep in the countryside an hour down the state highway.²⁶This itself is a form of implicit cross-subsidy. Because of economies of density, it costs much less to provide service to you than to your rural counterpart. This practice of setting the same rate for all residential customers in a large geo-graphic region such as a state—known as geographic rate averaging— means that you are in effect paying a hidden surcharge on your telephone bill to enable the rural customer to receive service at a rate well below the cost incurred in providing it to him.

On the other hand, you should not complain too much if you are an urban residential customer, for the corner grocery down the street from your apartment has even greater cause for dissatisfaction: it is likely pay-ing up to twice as much for a telephone line as either you or the rural inhabitant. That may seem odd, since it may well cost the telephone com-pany no more to provide that service to the grocer than to you. But this is another way in which regulators have typically kept residential rates low:

by authorizing the telephone company to maintain artificially high rates for “business lines.” In effect, when the grocer orders telephone service, he may be signing a tacit agreement to pay more than a 100% tax on that service to underwrite low rates for rural subscribers.

Long distance calls are another principal source of implicit cross-sub-sidies. The reason is somewhat complex. Before the 1980s, when there was very little competition in the long distance market, regulators set per-minute rates for such calls far above cost. Those rates helped underwrite low monthly rates on the bill for local telephone service. Throughout the 1980s and 1990s, as robust competition developed in the long distance market, long distance rates dropped significantly. But they often remained (and still remain) higher than “cost.” How is this possible, given the inter-city fiber glut and the strength of competition in the long distance market?

The primary answer lies in access charges, first discussed above. Let’s assume there is perfect competition in the market for city-to-city transport and other long distance services. There remains imperfect competition in the market for “access” services: i.e., for connecting end users to the net-works of their chosen long distance carriers, a task normally performed by

the traditional local telephone companies.²⁷ As a result, these “access”

charges are still generally capped by regulators, and they too are often set above any rigorous measure of “cost,” in part to offset the losses such com-panies are said to incur when they are forced to provide basic local service to residential customers at low rates. Since local companies impose access charges on long distance carriers, which in turn pass them on to their own subscribers, the net result is that long distance rates exceed the underlying costs of providing long distance service. Those who place many long dis-tance calls therefore end up subsidizing below-cost rates for “basic” local service. Since the 1996 Act, the FCC has reduced the levels of interstate access charges, but there is no consensus that it has succeeded in reducing all such charges down to levels that reflect a strict calculation of “cost.”

And there is little dispute that many states continue to set significantly above-cost access charges for intrastate long distance calls.

Yet another fertile source of implicit cross-subsidies is the sale of “sec-ond lines” to residential customers. Sec“sec-ond lines have long been popular among families with teenagers and people with home business offices. In the late 1990s, the number of second lines skyrocketed as people discov-ered dial-up Internet access yet wanted to avoid tying up the telephone for voice calls when on-line. The rates that state and federal regulators have imposed for these second lines are often twice as high as the rates for pri-mary lines, even though the extra copper wires needed for this service are usually already installed alongside the primary ones and cost very little to activate. In this respect as well, regulation has imposed, in effect, a sur-charge on heavy users of telephone service to help telephone companies afford the low rates they charge light users of that service. While political-ly expedient, such arrangements subvert a principle of economic efficiency called Ramsey pricing, which prescribes, for firms with large fixed costs, higher rates for essential services such as primary lines and lower rates for more discretionary services such as second lines or long distance services.²⁸ All these implicit subsidies—geographic cost averaging, above-cost business rates, above-cost access charges, above-cost second lines, among others—are politically convenient. They are all economically equivalent to a special tax imposed on some customers or services to subsidize below-cost rates for other customers or services. And, precisely because they are

“implicit” rather than “explicit,” they come without the political baggage of an explicit tax or universal service fee.

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But these are “taxes” with a special drawback: customers can avoid paying them altogether if they can find a provider other thanthe regulated local telephone company to perform the same services at a lower price—

i.e., without the implicit tax inherent in the regulated rate. New entrants in any market know this, and they will make it their first priority to cherry-pick the very customers who are paying the largest implicit taxes. This cherry-picking is a form of arbitrage—a low-risk profit opportunity arising from arbitrary distinctions. The new entrants that exploit such opportuni-ties inexorably undermine the whole scheme of implicit cross-subsidies, but they are doing nothing wrong. They are merely delivering the message that this traditional scheme, designed for monopoly market conditions, is unsustainable in a competitive era.

As discussed in chapter 10, the competitive entry stimulated by the 1996 Act will force regulators to find a more competitively neutral scheme for keeping residential telephone rates low. After all, regulators cannot deficit-finance their universal service policies indefinitely by requiring the incumbent local telephone companies to continue providing below-cost services without any source of subsidy. In the long run, as we shall see, the only options are higher residential rates for high cost customers or more explicit, tax-like fees for all customers. Neither option is politically appeal-ing, which explains why regulators have dragged their heels for so long in response to calls for genuine universal service reform.

III. Wireline Competition Policy Before 1996

To review, a market is said to have “natural monopoly” characteristics if, because of high fixed costs and large scale economies, a firm’s long run average costs “over the entire extent of the market”²⁹always decline with any increase in output. Throughout most of the twentieth century, the entire wireline telecommunications industry in the United States was treat-ed as a natural monopoly. The principal beneficiary of that policy was AT&T’s Bell System. AT&T and its subsidiaries were permitted to monop-olize the market for telephones and telephone equipment (Western Electric), the market for long distance services (AT&T Long Lines), and most major local exchange markets (the Bell operating companies). And those calling areas not served by the Bell System’s local exchange opera-tions were nonetheless served by some other state-sanctioned monopoly, such as GTE.

In chapter 1, we briefly introduced the major story in wireline commu-nications since 1970: the slow but steady peeling back of this natural monopoly premise from one market to the next until only fragments of the local exchange market were left. Over time, often as the result of techno-logical advances and the efforts of reform-minded regulators, policymak-ers repeatedly recognized that some segments of the telecommunications industry do not exhibit natural monopoly characteristics and should not be left as the exclusive preserve of the local telephone company. Each time, the government—either telecommunications regulators or antitrust authori-ties—adopted one means or another of ensuring that local telephone monopolies could not leverage their ownership of bottleneck facilities to preclude fair competition in adjacent markets for wireline telecommunica-tions-related services. The result was a hodge-podge of antitrust and regu-latory responses to different monopoly leveraging concerns, which persisted until partially superseded by the Telecommunications Act of 1996. Today, most public policy disputes about wireline competition are battles about how to implement the amorphous competitive objectives of the 1996 Act. We address those battles in chapter 3; this section sets the stage for that discussion by summarizing the development of wireline com-petition policy from 1970 through the eve of the 1996 Act.

Before 1996, as in more recent years, three basic opportunities tended to invite upstart carriers into particular telecommunications markets. First, competitors were attracted to markets in which call volumes were great enough that they, like the incumbent, could enjoy significant scale economies while serving only a fraction of the total customer base. Second, competitors were also attracted to any market, such as those that tradition-ally generated implicit cross-subsidies, in which the incumbent could be expected to hold a price umbrella over new entrants by charging its own retail customers rates higher than cost. This price umbrella enabled the entrants to undersell the incumbent while nonetheless earning substantial profit margins of their own. Finally, competitors were eager to fill niche markets—particularly for the provision of sophisticated data services—

that AT&T’s Bell System had largely disregarded through its century-long focus on ordinary voice telephony and its desire to avoid cannibalizing its existing revenues.

Between 1970 and 1996, competition arose in the markets that most clearly met one or more of these conditions: the “long distance” market for

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intercity transport, the “access” market for connecting large business cus-tomers directly to a long distance carrier’s network, and the emerging mar-kets for computer-to-computer data transmission services. In each case, what the upstarts needed most from the government were robust intercon-nection guarantees, in the form of “equal access” requirements, to keep incumbents from leveraging their dominance in the local exchange markets to exclude all rivals from adjacent markets. In the pages that follow, we summarize the history of competition in the long distance and access mar-kets and the relevant regulatory measures. We then turn briefly to the first, pre-1996 regulatory initiatives for bringing competition to local exchange markets. We begin, however, with the industry segment that fell prey to competition before any service market did: the market for telecommunica-tions equipment.The debate about competition in that market centered not so much on natural monopoly theory, for no one seriously suggested that equipment manufacturing itself had natural monopoly characteristics, but on the technical consequences of letting customers attach “foreign” (i.e., non-AT&T) devices to the telephone network.