Telecommunications equipment manufacturing

In the telecommunications world, the market for customer premises equip-ment (CPE) includes not just ordinary telephones themselves, but also the sophisticated private switches (PBXs) used in large office buildings, the

“modems” that enable computers to communicate with each other over telephone lines, and a variety of other devices. For decades, AT&T had cited dubious technical concerns as a pretext for prohibiting its customers from attaching to its network so-called “foreign” devices manufactured by companies other than Western Electric, its equipment manufacturing unit.

As AT&T’s chairman warned as late as 1973, “If consumers can plug any-thing they want into the network—any old piece of junk made who knows where—the system will break down. A faulty telephone in one house could conceivably disrupt service to an entire city.”³⁰As may seem obvious in ret-rospect, such concerns did not support AT&T’s argument for granting it an exclusive franchise to manufacture all telephone equipment. Instead, they supported, at most, the adoption of industry-wide standards that multiple manufacturers could follow in ensuring that use of their products would not harm the telephone network. But it took regulators decades to

recog-nize this fact, to overcome AT&T’s lobbying prowess, and to write the rules needed for robust competition in the equipment manufacturing mar-ket.

AT&T’s motives for resisting competition warrant a brief recap. As dis-cussed in chapter 1, an unregulated platform monopolist ordinarily recov-ers all supracompetitive profits in the sale of the platform itself (here, telephone service) and thus welcomes competition in the applications mar-ket (equipment manufacturing). This is because the more attractive and less expensive the applications are, the more valuable the underlying platform monopoly becomes. One wrinkle in telecommunications markets is that retail rate regulation has long limited the price the monopolist may charge consumers for use of the platform. Such regulation thus gives the monop-olist strong incentives to leverage its platform monopoly to obtain supra-competitive profits in adjacent, less price-constrained markets. The market for customer premises equipment fell into this category. As with long dis-tance and business services, regulators had permitted the price of telephone equipment—which often took the form of monthly lease rates—to remain well above its underlying cost in order to subsidize inexpensive local serv-ice for residential customers.³¹

AT&T’s monopolistic hold on the equipment market showed its first signs of erosion in the 1950s and 1960s. During the multi-year Hush-A-Phonecontroversy, AT&T prohibited its customers from attaching an inde-pendently manufactured cup-like device to a telephone receiver for the modest purpose of limiting background noise. The FCC absurdly agreed with AT&T’s submission that the use of such “foreign devices” threatened the integrity of the telephone system, even though the practical effect of the device was equivalent to covering the receiver with one’s hand.³² A bemused court of appeals reversed the FCC’s decision in 1956 on the ground that it made no sense.³³The FCC eventually learned its lesson: in 1968, after much hand-wringing, it rejected AT&T’s efforts to bar the use of the “Carterfone,” a device that connected a telephone line to a two-way radio, so that people using the radio could gain access to the telephone net-work and those on the netnet-work could communicate with those using the radio.³⁴

Throughout the 1970s, the FCC built on these precedents in two basic respects. First, in 1975, it created the Part 68 rules,a set of technical stan-dards that, once met, entitle any equipment manufacturer to sell its wares

Introduction to Wireline Telecommunications 59

to the public and demand cooperation from the telephone companies.³⁵ The Part 68 rules supplanted AT&T’s last-gasp efforts to discriminate against equipment manufacturing rivals by forcing them to purchase, from AT&T, various “protective coupling devices.” The ostensible purpose of those devices was to protect the integrity of the telephone network, but their actual effect was to raise rivals’ costs and hamstring competition in violation of the antitrust laws, as the courts later found.³⁶

Second, in connection with a set of orders in the 1970s and 1980s known as the Computer Inquiries, which we discuss more fully in chapter 5, the FCC required telephone companies for a time to sell equipment through structurally separated subsidiaries and to “unbundle” such sales from their telephone service offerings. This “separate subsidiary” require-ment was designed (i) to keep telephone monopolies from anticompetitive-ly linking their products in these two markets and (ii) to help regulators detect any effort by these monopolies to cross-subsidize their equipment operations by allocating excessive joint and common costs to their regulat-ed telephone service rate base. (We discuss cross-subsidization concerns and the nature of joint and common costs in greater detail below.) By facil-itating competition in the equipment market, the FCC’s new rules triggered not just an enormous decline in prices for telephones and other equipment, but also an explosive growth in the variety of end user devices. These included computer modems, whose proliferation helped launch the Internet into public life.

Finally, when it broke up AT&T’s Bell System in 1984 under the con-sent decree discussed below, the antitrust court prohibited the seven newly independent regional Bell companies (the “Baby Bells” such as Bell Atlantic, Ameritech, and BellSouth) from manufacturing telecommunica-tions equipment. This line-of-business restriction included not just cus-tomer premises equipment, but also the very core of the telephone network, such as central office switches. In section 273 of the Communications Act,³⁷added by the 1996 legislation, Congress replaced that antitrust pro-hibition with similar, statutory line-of-business restrictions, but it enabled the Bell companies to escape many of those restrictions once they satisfied certain conditions for opening their local markets to competition, as they now have.