Long distance competition and the AT&T consent decree

Much of telecommunications policy in the final quarter of the last century involved efforts by the Justice Department’s Antitrust Division and a fed-eral district court to keep AT&T’s Bell System and, after divestiture, its Bell company progeny from leveraging their control over localmarkets to dom-inate the long distancemarket. Throughout most of the twentieth century, this was no issue at all because AT&T owned the only significant city-to-city transport facilities (AT&T Long Lines). For quite some time, these facilities were also considered part of the vast natural monopoly of telecommunications, and the FCC permitted AT&T to charge above-cost rates for long distance service as one mechanism among many for subsidiz-ing low residential rates for basic service.

The assumption that the long distance market was a natural monopoly changed when, in the late 1960s and early 1970s, a small upstart called Microwave Communications, Inc.—now famous as MCI—first offered business customers city-to-city services using a new technology, microwave relay towers, to bypass AT&T’s Long Lines. It is no surprise that the first major competition in the telecommunications industry came in the long distance market. As discussed, long distance rates were priced far above cost, and the call volumes between cities are typically great enough to pro-vide large economies of scale to more than one carrier. A third factor was at work as well. The birth of modern computing had made businesses across the economy hungry for new data services involving communication between distant computers over telephone lines. For example, a given busi-ness might need ready access to airline flight schedules, financial market data, or the databases of Lexis-Nexis. Like most monopolies, the Bell System had been slow to adapt to the demand for these innovative data services, which then occupied only a niche market, and had continued to focus on its bread and butter: providing ordinary voice service. The entry of specialized data carriers like Datran, Telenet, and Tymnet, which designed specialized digital networks to carry computer traffic, came as a welcome contrast to Bell’s continued reliance on outdated analog technol-ogy.

The vanguard of competition, however, was MCI, and its first ambi-tions were modest. It began by offering “private lines”—i.e., closed, point-to-point circuits—connecting the branch offices of large businesses in

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different cities. In granting MCI’s application as a “specialized common carrier,” the FCC noted the unmet demand for these private lines, includ-ing for use in data communications. Over time, MCI persuaded the FCC to let it go one step further and provide so-called FX (“foreign exchange”) lines to its business customers.³⁸These were private lines with a twist: one end connected to the Bell System’s local exchange. Thus, MCI’s FX line might connect two offices of the same company—say, one in New York and one in Chicago—but in New York, the line was assigned a local tele-phone number, and calls to that number appeared, from the perspective of the Bell company switch, to be ordinary local calls. Equipped with an access code, the company’s employees could dial that number from any-where in New York and, for the cost of a local call, be connected to the company’s office in Chicago. Similarly, a ski resort in the Rocky Mountains might purchase a private line with the “open” end in Denver. The line would permit Denver residents to dial a local number to reach the resort and would enable the resort itself to place seemingly local calls to its own Denver suppliers. In each case, AT&T’s Long Lines division would receive no toll revenues, and MCI would charge only a flat rate for the private line.

The final step in MCI’s development, which marked its full emergence into the long distance (and not just private line) market, came in the form of a controversial new service called Execunet, first offered in 1975 and judicially validated in 1978.³⁹Execunet involved, among other things, the use of private lines that were “open”—i.e., connected to Bell’s local exchange—on bothends rather than just one. To take the example above, this meant that anyone authorized to gain access to the private line could call from anywhere in Chicago to anywhere in New York and vice versa, without paying toll charges to AT&T. Before long, MCI used such lines to make general-purpose long distance services available to the public at large: i.e., not just to the employees of large subscribing businesses, but to individual consumers as well that signed up with MCI. Separately, MCI also sought and received regulatory enforcement of the right to purchase AT&T’s long distance services in bulk at the standard volume discounts available to AT&T’s large business customers and then resell those servic-es to customers of its own.⁴⁰

AT&T’s effective cooperation in providing non-discriminatory access to its local exchanges was essential to MCI’s prospects in the long distance market. Because MCI could not possibly duplicate the Bell System’s local

facilities, its long distance network would be of little use if, because of Bell System recalcitrance, MCI had no feasible way to connect its network to its customers and to the parties those customers wished to call. AT&T understood that the denial of effective interconnection was a powerful anticompetitive tool, just as it had understood the same fact 60 years before, during the events leading up to the Kingsbury Commitment (see chapter 1). Consequently, AT&T fought tooth and nail to deprive MCI of effective access to its network. At one point, AT&T even unplugged from its local networks the supposedly “open” ends of the FX lines MCI had sold to its customers.⁴¹AT&T sought to justify its anticompetitive conduct on several grounds. Most fundamentally, it argued that permitting MCI to cherry-pick AT&T’s highest margin customers in the long distance mar-ket—those who had been paying supracompetitive rates for many years—

would undermine the commitment to “universal service” and would require substantial increases in local service rates in order to support the maintenance of the nation’s telephone network.

In several different contexts, courts and regulators rejected AT&T’s policy justifications and awarded its competitors a series of incremental victories until, in 1982, AT&T and the Justice Department entered into an antitrust consent decree (consummated in 1984) that required the complete divestiture of the Bell System’s local exchange facilities from AT&T.⁴²The decree also prohibited the newly independent Bell companies from provid-ing long distance services themselves until they had satisfied the antitrust court that doing so posed no threat of anticompetitive behavior.

There were two basic rationales for splitting up AT&T and for quar-antining the Bell companies, for the most part, to local telecommunications markets. The first was a concern about operational discrimination. AT&T had already agreed to interconnect with MCI’s long distance network—i.e., to allow the use of its local exchange facilities to originate calls bound for MCI’s network and to complete calls on the other end. But, as noted in chapter 1, there are many subtle ways in which a dominant carrier can cre-ate interconnection problems for new entrants. For example, it can reserve insufficient capacity on its interconnection trunks to meet customer demands for access to the rival long distance company’s network during peak calling periods. AT&T Long Lines had given customers good reasons to perceive that, because of its affiliation with the Bell companies, they would get more dependable service from AT&T than from MCI. The fear

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was that, if the newly independent Bell companies were permitted to enter the long distance market, they—like the integrated AT&T before them—

would find ways to discriminate in favor of their own long distance oper-ations.

For good measure, the antitrust decree further subjected the Bell com-panies not just to this line-of-business restriction, but to affirmative equal accessobligations as well. These requirements directed the Bell companies to upgrade their equipment to give AT&T’s long distance rivals the same access as AT&T itself to the Bells’ local networks. For example, in the 1980s, many subscribers that wished to avail themselves of MCI’s low rates had to dial an access code first to reach MCI’s network, wait for a second dial tone, and only then enter the digits of the party they wished to call.

These extra dialing steps, which AT&T’s long distance customers never confronted, inconvenienced MCI’s customers and thus disadvantaged MCI in the long distance market.Dialing parity requirements, a type of equal access obligation, fix that problem by directing each local telephone com-pany to reconfigure the connections between its switches and the networks of various long distance companies so that an end user can “pre-subscribe”

to the long distance provider of her choice and need dial only “1” plus the called party’s number to have her long distance calls carried by that provider.⁴³

The other basic concern underlying the Bell companies’ exclusion from the long distance market related to predatory cross-subsidization, to which we referred in the equipment manufacturing context. Under traditional rate-of-return regulation, the rates that the pre-divestiture AT&T could charge its local customers for particular services were set, in part, on the basis of the “costs” that appeared in its accounting books in connection with those services, plus a reasonable profit. But AT&T had a great many costs and a great many services, and matching particular costs to the par-ticular services that “caused” them was an exercise in extreme subjectivity.

Costs that were “joint and common” to a number of services—such as loop costs—were especially subject to manipulation because they did not truly belong to any one service category. Thus, whenever competition arose, AT&T enjoyed considerable discretion to assign costs away from compet-itive markets—thereby lowering prices and underselling rivals—and to attribute those costs instead to its operations in uncontested markets, where its captive customers would be forced to pay marginally higher

rates. If successful, these surgical strikes on new entrants would enable AT&T to retain its monopoly position in most markets without threaten-ing its ability to maintain relatively low residential telephone rates over the long term. Here again, the fear was that, if permitted to enter the long dis-tance market after their separation from AT&T, the Bell companies would exploit the same anticompetitive opportunities as AT&T’s integrated Bell System.

In the years following entry of the consent decree, these twin con-cerns—operational discrimination and predatory cross-subsidization—

gradually became less compelling as a justification for the Bells’

line-of-business restrictions. First, price cap regulation, both on the federal level and in many states, significantly alleviated the risk of predatory cross-subsidization. In particular, it prevented the Bell companies from obtaining near-automatic recovery of their book costs and thereby reduced their incentive to allocate all joint and common costs to their regulated opera-tions while slashing prices to undercut competition in contested markets.⁴⁴ Indeed, the many local exchange carriers throughout the country that were notthe offspring of AT&T’s Bell System werepermitted to offer long dis-tance service during this period, and the FCC had developed accounting and other safeguards to protect unaffiliated long distance carriers from predatory conduct.⁴⁵ As for concerns about operational discrimination, years of successful administration of the equal access rules—in both Bell and non-Bell territories—had raised questions about the need for full-blown line-of-business restrictions to protect competition in the long dis-tance market.⁴⁶

Citing these developments, the Bell companies argued to the antitrust court in the years preceding 1996 that the decree’s outright restriction on their entry into the long distance market was no longer warranted. In 1996, Congress largely rejected these arguments by perpetuating these line-of-business restrictions in statutory form—but it did give the Bell compa-nies a statutory mechanism for overcoming those restrictions, as we discuss in the next chapter.