The Heritage Foundation

Issue Bulletin #191

June 3, 1994

June 3, 1994 | Issue Bulletin on

A Guide to Telecommunications Deregulation Legislation

(Archived document, may contain errors)

191

June 3, 19%

A GUDE TO TELECONDAMCATIONS DERMUIAIION

INMODUMON The technological boundaries between long-distance telephone service, regional tele- phone service, cable television, computer technology, and other multi-media communica- tions services are becoming increasingly blurred. Innovation in the telecommunications industry is occurring so rapidly that the same service today can be carried by different technologies and industries. Within ten to twenty years, to refer to these technologies as separate sectors will be meaningless. These many voice, video, and data services are rap- idly combining to create a new communications medium known commonly as "the infor- mation highway." Once in place, this highway will allow Americans to access these com- bined services right from their living room through their television sets, telephones, or computers. In essence, the information highway represents nothing more than removal of regula- tory barriers that have been ardTicially holding back these innovations. Today, the devel- opment of an information highway is being constrained by a patchwork of different fed- eral, state, and local regulations that have erected artificial barriers between the local tele- phone, long distance, cable, broadcast, and computer informational services industries. The result of government intervention throughout this century has been mar- kets preserved through government protection. Congress may at last be poised to remove many of these barriers, and so speed the crea- tion of a fully interactive telecommunications system. Lawmakers are considering legisla- tion that, if passed, will free the ecommunications, industry of some of the archaic regu- lations which now restram innovation and consumer choice. Two bills in the House, the Antitrust Reform Act (H.R. 3626), sponsored by Representatives Jack Brooks (D-TX) and John Dingell (D-MI), and the National Communications Competition and Informa- tion Infrastructure Act (H.R. 3636), sponsored by Representatives Edward Markey (D- MA) and Jack Fields (R-TX) have been reported by the House Judiciary and Energy and Commerce Committees. Meanwhile, in the Senate, the Coninumications Act of 1994 (S. 1822), sponsored by Senator Ernest Hollings (D-SC) combines elements of both House bills. If imp the legislation will:

V Allow the Regional Bell Operating Companies (RBOCs) or "Baby Bells" into the long-distance market after certain criteria are met. The court agreement that led to the break-up of AT&T into regional telephone companies restricted the so- called Baby Bells to local phone service and legally prevented them from entering the long-distance market. Removing this barrier would mean even greater competition will develop within long-distance markets, bringing consumers greater savings. V Eliminate other "line-of-business restrictions" on the Baby Bells. These restric- tions currently prohibit the Baby Bells from manufacturing telephone equipment, pro- viding alarm monitoring systems, and reselling long-distance telephone service. Re- moving these barriers also would increase the number of providers of telephone equip- ment and service, and so offer consumers better quality goods and services for lower prices. V Eliminate the "cable-telco ban." This prohibits telephone companies, or "telcos," from delivering video and data services over their networks. The barrier represents the most serious impediment to the creation of an information highway. Ending the ban would allow it to develop more rapidly and efficiently. While these bills break down regulatory barriers, they also contain several flaws which will offset many of these gains and slow down the development of the information high- way. To ensure this does not occur, Congress would be wise to amend the current propos- als to: Remove competitive entry requirements. The proposed legislation would require that Baby Bells and cable companies meet multiple requirements before they are al- lowed to enter new markets. These restrictions are supposed to make sure that no firm can gain an unfair advantage in any new field it hopes to enter. However, the effect of thew restrictions would be to act as barriers to entry and so deter competition. For ex- ample, requirements allowing telcos into each other's markets only after they prove their local markets are competitive will backfire since those markets will only become competitive by allowing new firms to enter immediately. V Eliminate separate affiliate requirements. The legislation requires that the tele- phone and cable firms wishing to expand into new markets do so only via affiliated businesses to prevent them from using profits Erom a regulated portion of its business to subsidize an unregulated division. (Regulated portions of the telecom industry often have their profits guaranteed by regulators.) Such operating limitations are intended to prow rate payers from having to pay fbr industry expansion. However, this problem could be mom easily solved by reforming or eliminating rate regulation for firms whose rates have been bureaucratically maintained and sheltered from market competi- tion. V Tadde monopolistic concerns by removing governmental barriers to competi- tion. Although government intervention at all levels was intended to address the dan- ger of monopoly, this intervention has contributed more to the creation of monopolies than private firms have. The legislation unwisely expands antitrust enforcement in- stead of focusing on removing government barriers to competition. Expanding anti- trust enforcement would discourage competitive alliances and mergers. which we needed in this industry, while greatly increasing litigation costs.

Reject the temptation to expand the definition of "universal service." Both the Senate and the House bills mandate communication providers to expand the package of basic services that every household receives. Instead of the simple telephone serv- ice now required, companies would have to provide a broader package which later would be defined by the Federal Communications Commission (FCC). While this is intended to provide Americans with a wider array of communication and information services, it could lead instead to two or three large companies dominating the market. The reason: smaller providers, lacking the economies of scale of larger firms, will be ill-equipped to provide a comprehensive basic service and consequently would be less competitive and perhaps forced out of business. V Eliminate exclusive purchasing and domestic production requirements. The leg- islation mandates that the manufacturing of equipment by the Baby Bells must be un- dertaken within the U.S. and that a specified percentage of their parts must be pur- chased from domestic producers. Such protectionist provisions make little economic sense since they would encourage companies to divert their resources to less produc- tive uses and would deny customers access to the best value for money. In addition, domestic content requirements have been found by the Clinton Administration to be in violation of existing trade agreements. In addition, Congress should take advantage of this important opportunity to complete the deregulation of the telecommunications industry. There are a number of steps that need to be taken to free up the cable, broadcasting, and emerging technologies from regu- Mons in order to promote competition and technological innovation. Congress should take the following steps or order the appropriate agencies to carry them out: I ) Repeal the Cable Consumer Protection and Competition Act of 1992. The new cable rate restrictions will limit the cable industry's ability to compete successfully along the information highway by restricting the amount of capital they can re-invest in new ventures. 2) Create a more flexible spectrum allocation process to ensure the rapid deployment of new technologies. Over six decades of inefficient spectrum management by the federal government has consistently discouraged the competition which potentially could have flowed from wireless services, such as cellular telephones, personal communication services (PCS), and sateMte technologies. Privathing the spectrum would finally remove barriers to full-fledged wireless competition and ensure that wireline providers are faced with a formidable challenge. 3) Allow mergers and acquisitions to go forward without threat of antitrust enforcement. Restricting on alliances among the various industry segments, such as the recent AT&T-McCaw Cellular merger order by the courts, will destroy the rapid and efficient spread of the information highway. Congress should instruct the Department of Justice and encourage the courts not to block such beneficial merger and acquisition activity. 4) Allow any company to own as many television or radio stations as it wishes. Traditional television and radio broadcasters will play an important role in ft development of the information highway, but only if Congress lifts ownership restrictions that limit their efforts to extend service. These restrictions simply prevent the dissemination of programming and further discourage competition with other industry segments. 5) Encourage a broader role for private sector firms, cooperative groups of firms, or other private organizations when setting standards for emerging technologies. Instead of pushing arbitrary standards on the industry, as it often does elsewhere, Congress should order that the FCC allow private interests the time to freely test and develop standards that will produce marketable products. Mandating a single standard before it has proven worthy could slow industry innovation. 6) Eliminate foreign ownership barriers. Currently, foreign firms cannot own more than 25 percent of an American telephone company or 20 percent of a radio license. These protectionist barriers restrict industry expansion and competition by turning away much needed capital and technological know-how. Congress should order the FCC to eliminate them immediately. 7) Devise a schedule for the phase-out of federal, state, and local rate regulation. All levels of government regulate rates in the name of consumer protection. However, rate regulation has sheltered larger service providers from competition by creating an unfair and inefficient rate structure. States and municipalities have more responsibility over rates, but if competition is sharpened by federal deregulation, the argument for state and local regulation evaporates. Thus together with federal deregulation, Congress should encourage the state and local reform process by developing deregulatory recommendations for the area of jurisdiction to permit rates to adjust fi-eely to accommodate market demands in the more competitive environment. The firne is long overdue for comprehensive telecommunications law reform. Failing to act while the opportunity exists could slow industry innovation and future competitive- ness. In addition, inaction means consumers will not be able to access numerous technolo- gies for a low cosL And without comprehensive reform that encourages intense rivalry and innovation, the American economy will suffer as domesuc firms are forced to turn elsewhere for superior products or do without these technologies. The era of sheltered, regulated monopolies must give way to an age of multiple, competitive teleco .ca- tions providers if America hopes to retain its status as a leader in this industry - and in the many industries that depend on its products and services.

AN OVERVIDEW OF TELECOBEM[UNICATIONS REGULATION Federal, state, and local governments have regulated the telecommunications industry throughout this century. Although the intent of regulation was to extend service to as many Americans as possible, the price paid for that social goal has been the creation of uncompetitive, sheltered monopolies. Not only has government regulation meant monop- olies within several segments of the industry (such as telephone, cable television, and most broadcasting), but it has protected those monopolies from competition. In addition, the regulatory split between local, state, and -federal regulatory agencies creates jurisdic- tional headaches for fmns and for consumers. When viewed in its entirety, this system is responsible for the complex web of inefficient, and often contradictory, regulations that discourage true telecommunications competition and have triggered demands for deregulation. Consequently, unlike a competitive market, the telecommunications market is dis- torted by inefficient pricing, a lack of product and service innovation, and limited entry by new firms. How the AT&T monopoly developed. The telecommunications industry used to be considered a textbook case of natural monopoly. A natural monopoly is said to exist when a single firm is able to control most, if not all, output and prices in a given market due to the enormous cost barriers facing new entrants and economies of scale favoring the largest producers. For example, telephone service traditionafly has required laying an extensive cable network, as well as the construction of numerous call switching stations and the creation of numerous support services, before service can actually be initiated. Obviously, with such high entry costs, new firms can find it difficult to gain a toehold in this industry. These problems are compounded by the fact that once a single firm over- comes these initial costs, their average cost of doing business drops rapidly relative to newcomers. Overlooked, however, is the extent to which federal and state governmental actions throughout this century helped build the American Telegraph and Telephone (AT&T) or "BeH systerre' monopoly. As Robert W. Crandall of the Bmokings Institution notes, "De- spite the popular belief that the telephone network is a natural monopoly, the AT&T mo- nopoly survived until the 1980's not because of its naturalness but because of overt gov- ernment policy." I In the early years of this century, vigorous competition did exist within many local tele- phone markets. Although patent protection allowed the Bell system to develop without threat of competition throughout the late 1800s, by the turn of the century the number of independent firms was rising dramatically and over 3,000 competitors existed. Illinois, In- diana, Iowa, Missouri, and Ohio each had over two hundred telephone companies com- peting within their borders. 2 By 1907, non-BeD firms operated 51 percent of the tele- phone businesses in local markets. 3 Many urban subscribers, moreover, were able to choose among competing telephone providers, driving prices down considerably. AT&T's profits and prices during this period began moving downward thanks to this in- creased competition. Whereas AT&T had earned an average return on investment of 46 percent in the hft I 8Ws, by 19M their return had dropped to 8 percent. 4 AT&T offered to attempt to extend telephone service to every American while not ac- quiring other rivals in exchange for Hinited government protection from competition. AT&T's proposed policy, refermd to by company executives as'Guniversal service:'was adopted as federal regulatory poRcy when, during World War I, the federal government took over the entire telephone industry for one year for national security reasons. This turned out to be the nail in the coffin of competition. As industry historians Leonard S. Hyman, Richard C. Toole, and Rosemary M. Avellis note: During this period of government ownership, the decision was made to set stand- ard long-distance rates throughout the country, based on average costs. In other words, subscribers calling from large cities would pay above costs in order to pro- vide a subsidy to those-in rural areas. So. early in the century cross-subsidization began, embraced by the industry, which rarely question the premise behind the ar- rangement that the ability to communicate with subsidized subscribers was of value to the subsidizing subscribers. As long as the telephone industry had a mo- nopoly and regulators approved of the arrangement, it did not matter what sub- scribers wanted They had no choice. 5 Despite attempts to inject competition into the system after World War I, the over-rid- ing goal of universal service required a flim with the economies of scale only AT&T pos- sessed. Without the size or financial resources of AT&T, non-Bells could not meet gov- ernment demands for lower rates on rural service. Universal service was finally codified as the raison d1tre of the Federal Communications Commission under Section 151 of the Communications Act of 1934.6 The policy was attractive to the activist government of the period since telephone service was increasingly considered a necessity for all Americans. Hence, owing to a federal policy that placed higher value on immediate uni- versal service over competition, the Bell monopoly was solidified. Franchising and Monopoly. At the local level, a similar process allowed cable mo- nopolies to develop as both the federal and local governments shielded providers from competition. Despite initial FCC efforts to restrain competition to ensure the then-power- ful television broadcasters' monopoly remained inmct, cable systems developed rapidly after 1970. 7 Yet, at the same time, municipalities were awarding exclusive fi-anchises to cable television providers, partially in exchange for their agreement to broadcast a certain amount of locally produced FLUSLaunming. This policy allowed cable monopolies to de- velop in 97 percent of local markets.8

The FCC and Congress have often made it much easier for these local monopolies to maintain their dominance by blocking the most logical competitors-local telephone companies-from entering the market. An FCC decision dating from the early 1970s that restricted telephone companies from providing cable television (or any video program- ming) was codified by Congress in the 1984 Cable Communications Policy Act. The re- sult of this "cable-telco ban," as it is known, is that monopolistic cable franchises are shielded by the government from potential competition with both local and long-distance telephone companies. 9 The Cable Consumer and Protection Act of 1992, which imposed rate regulation on the industry, would probably not have been necessary if telcos were al- lowed to provide video services. This competition would have driven down rates natu- rally. Franchising or licensing policies can have anti-competitive effects in other arenas. For example, competition within local cellular markets is arbitrarily limited to the two firms that may receive federal spectrum licenses to provide service in each region. One of the two licenses must always be awarded to the local telephone company, presumably to ap- pease their concerns about rising competition. (This type of spectrum licensing could con- tinue to create problems as wireless technologies are developed that require additional spectrum space.) Likewise, television broadcasters have traditionally been granted protec- tion in local markets since federal regulators grant only three VHF licenses per market. New conunon telephone carriers also are required to obtain operating licenses from the FCC, which artificially limits the number of firms in any given market. The Breakup of the Bell System. During the early 1970s, the Department of Justice (DOJ) began to recognize that the Bell system, which essentially was created by govern- ment action, discouraged competition by restricting entry. In 1982, after an eight-year an- titrust investigation, the DOJ and AT&T came to an agreement on the terms of a divesti- ture agreement to break-up the company. U.S. District Court Judge Harold H. Greene pre- sided over the agreement, referred to as the Modification of Final Judgment WJ). It went into effect on January 1, 1994. The MFJ required that AT&T surrender control of its 22 local operating companies to seven new regional service providers refeffed to as the Regional Bell Operating Compa- nies or, as they are more commonly known, the "Baby Bells@"The agreement prohibited AT&T from holding interest in any of the Baby Bells and limited it to providing long-dis- tance service between the telephone exchanges. AT&T was allowed to enter the com- puter industry, thougk and to continue to produce telephone equipment and conduct re- search and development. The Common Carrier Bureau of the FCC regulates its service and rates. The seven new Regional Bells were also given distinct operating guidelines. Aside from providing local phone service, they were required to furnish all long-distance providers access to customers in their region, purchase equipment and services from a va- riety of providers, and were prohibited from providing long-distance services, manufacturing telephone equipment (although they could sell it), or from delivering informational services. (In 1991, the ban on informational service delivery was lifted after a successful court challenge.) The Baby Bells were restricted from entering these markets since policy makers believed they would use profits from the regulated portion of the business to sub- sidize these other sectors, keeping competitors out. These "line-of-business restrictions" and the requirement that the Baby Bells provide service only within a specific Local Ac- cess and Transport Area or "LATA," means fully fledged competition between the RBOCs and the interexchange carriers (IXCs or long-distance firms) cannot take place. Rate Regulation. The final, and perhaps most important piece of the regulatory puz- zle, is telephone rate regulation. Federal, state, and local rate regulation has existed for decades and continues to plague efforts to bring competition to the marketplace. Two jus- tifications have been advanced for rate regulation. First, rates must be "fairly" assessed (that is, low-cost) for customer service, it is said, since in most cases only one monopo- listic provider exists to serve each region. Second, the regulated firm must be permitted to earn a stable profit to ensure continuous service. In line witli these objectives, rates today are manipulated by local regulators to ensure universal service requirements are satisfied. Due to legislative pressure at both the state and local level, regulators subsidize more costly rural and residential service by raising the rates of long-distance and business customers. Not surprisingly, this arrangement has been found to be extraordinarily inefficient. Estimates by economists of the efficiency losses due to these discriminatory rate charges run between $1.5 billion to $10 billion per year. 10 Rarely can more than one firm in a region afford to meet these regulatory require- ments and built-in inefficiencies. Thus, a single telco typically services the area and is provided with sustained revenues, not because of consumers, but because of actions by regulators. In the long-distance market, the rates of smaller providers, such as Ma and Sprint@ are not heavily regulated by the FCC. But AT&T, as the "dominant carrier" of long-distance service, still is heavily regulated. A recent shift in FCC regulatory policy from rate-of-return to price cap rate regulationi I has helped eliminate some of the ineffi- ciencies created by regulation by encouraging greater innovation, but it is still no substi- tute for market competition. Some states have followed the FCC's lead by switching to more pro-competitive regulatory policies, but the disincentives created by cross-subsidi- zation of residential service still exist.

WHY DEREGULATION IS NEEDED With technological innovations, as well as industry mergers and acquisitions, occurring so rapidly, legislators and government officials now realize that regulations an the books since the early 1930s are ill-suited to govern how competition within the industry takes place today. Even the 1982 Consent Decree is now considered out-of-touch with the real- ity of modem technology. Note William J. Baumol of New York University, and J. Gre- gory Sidak of the American Enterprise Institute: "[T]e1ephony, broadcasting, cable televi- sion, and mobile communications are fast becoming activities whose main difference is their regulatory treatment, rather than their technological or economic characteristics. 9912 Despite the many regulatory hurdles firms face, the industry is innovating rapidly. With the advent of cellular services, advanced satellite delivery equipment, computerized com- munication technology, digital compression technology, fiber optic wiring, pagers, ad- vanced cable systems, and specialized business communications equipment, the Ameri- can telecommunications industry is in the midst of a breathtaking technological revolu- tion. These new industry spinoffs have forced analysts and regulators to reassess the en- fire state of competition within many markets. As Peter Huber, senior fellow with the Manhattan Institute notes, what DOJ lawyers and Judge Greene failed to realize when they handed down the MFJ decision was that many of these technologies were already converging at the local level to create more competitive markets. Most important, wire- less networks were developing to challenge the Bell system's monopolistic wireline serv- ices. 13 Today, competition in local markets has spread rapidly. As Business Week wrote in 1992, "Almost nine years after the regional companies were spun off .. [the Baby Bells] are feeling queasy. Competition and new technology are crowding into their lucrative mo- 9914 nopolies in local phone service. For example, rival local cellular networks have experi- enced explosive growth. According to wireless consulting firm Herschel Shosteck Associ- ates, cellular penetration of the business market has risen from a negligible level in 1983 to 16.8 percent in 1989 and, the firm projects, will continue to rise to nearly 70 percent by 1995 and 97 percent by 2005. Competitive Access Providers (CAPs) and Metropoli- tan Area Networks (MANs) have also arisen in local business districts to provide a viable alternative to local telephone exchange companies. These alternative il ss providers or ALTe' as commonly known in the industry, provide high-capacity, fiber optic-based services primarily to urban businesses and long-distance firms so they can bypass the lo- cal telephone companies entirely. 15 Satellite-based technologies, such as Personal Communication Systems (PCS), will also create a formidable challenge to both traditional lo- cal and long-distance wireline providers. PCS will allow crystal-clear point-to-point com- munication between individuals who may be in different countries. Many traditional industry barriers to competition are likely to fall in the face of these advancing technologies, as well as the rapid rise of merger and acquisition activity within the industry. For example, regulators have long been concerned with the supposed "bot- tleneck" local providers may impose on residential consumers. The fear is that customer access to services could be denied if regulations did not require the local companies to guarantee interconnection with all long distance providers. Yet recent industry activity, such as the merger of AT&T and McCaw Cellular Communications, could make this sup- posed entry barrier irrelevant. If approved by the court, this merger would marry the tech- nology of the nation's largest long-distance provider to the largest cellular provider, effec- tively creating a vertically integrated telecommunications firm. 16 AT&T then would pos- sess the wireless capabilities to overcome the entry barriers remaining at the local level since they will no longer have to rely on local wireline networks to reach customers. 17 A similar deal recently has been announced by MCI Communications (AT&T's leading compqtitor), who plans to acquire interest in Nextel Communications, a new wireless firm.18 MCI has also allied with Comcast (a cabletcellular firm) and the wireless giant Motorola in an attempt to develop the first nationwide PCS network. 19 Meanwhile, the Baby Bells have also been merging with alternative telecommunication service providers at a rapid pace. 20 The Need for Change. Although competition is evolving and technologies proliferat- ing, government action still is needed to remove the remaining barriers along the informa- tion highway. The fact is that many technological innovations have come about as an ef- fort to adapt to regulations, not so much because of some new market opportunity. So in- stead of finding creative ways around the current regulatory structure, firms should be al- lowed to find more innovative ways to provide consumers the services they want.

Among the benefits of eliminating these regulatory barriers: It would encourage competition between industry segments. Competition be- tween various industry segments has been restricted by many years of governmental protection of monopolies. For example, regulation has established monopolies and then restricted entry into the telephone, broadcast, and cable industries. But once com- petition is allowed to develop between cable and telephone fmns, local and long-dis- tance telephone firms, wireless and wireline telephone services, and between other in- dustry segments, any vestiges of monopoly will soon disappear. It would speed the development of the information highway. Regulation is the major impediment to the completion of the information highway. Besides restricting competition between industry segments and creating monopolies, regulation has slowed the efforts of many firms wishing to build the highway. Recent decisions by the FCC to reregulate the cable industry, and Judge Greene's decision to prevent the AT&T-McCaw merger, illustrate why firms cannot progress as rapidly as they might like. V It would greatly benefit the American economy and citizens. Regulation has also limited the general competitiveness of the industry. For example, the Baby Bells are not allowed to manufacture telephone equipment. Allowing them to do so would cre- ate new jobs and exports for the economy. The WEFA Group, an economic forecast- ing firm in Burlington, Massachusetts, estimated last year that if aU telecommunica- tions regulations were removed, some 3.6 million more jobs would be created by 2003 than could be expected without deregulation. The firm estimated that the economy will grow, on average, 3.3 percent per ear with telecommunications deregulation, but only 2.9 percent annually without. I IIn addition to the new job opportunities that could result from deregulation, consumers would also benefit from the increase in services available to them. The WEFA study found that consumers could expect sav- ings of approximately $63 billion a year with deregulation. 22 Exports of high-tech tele- com products, in which America currently has an advantage. could also increase greatly if more companies are allowed to manufacture equipment.

THE DEREGULATORY LEGISLATION IN CONGRESS To make possible the many benefits of deregulation, three bills recently were intro- duced in Congress. These would help correct some of the flaws in today's system of rep- lation. A Senate bill would combine elements of two House bills and takes a more com- prehensive approach to deregulation overall. The three bills am: the Antitrust Reform Act (H.R. 3626). sponsored by Representatives Jack Brooks (D-TX) and John Dingell (D- W; the National Communications Competition and Information Infrastructure Act (H.R. 3636), sponsored by Representatives Edward Markey (D-MA) and Jack Fields (R-TX); and the Communications Act of 1994 (S. 1822), sponsored by Senator Ernest Hollings (D-SC).

Although the White House backs the general goals of the proposed legislation, the Clin- ton Administration has also proposed to add a new Title VU to the Communications Act of 1934, which would apparently streamline the regulatory process for emerging cable and telephone competitors. Although the Administration's proposal might ensure minor gains relative to the legislative approach to continuing regulation, unfortunately it is the continuing regulation itself that poses the greatest hurdle to increased competition. Such minor process reforms will be df little overall consequence. H.R. 3626 has been reported out by the House Energy and Commerce Committee and the Judiciary Committee, and is expected to reach the floor once the chairmen complete negotiations on which version should be considered. H.R. 3636 has cleared the House En- ergy and Commerce Committee, which had sole jurisdiction over it. The Senate Com- merce, Science, and Transportation Committee has held hearings on S. 1822, but there has been no other action yet in the Senate. While each bill makes important deregulatory contributions, each also contains flaws that need to be addressed before the measures are merged and potentially become law. WELCOME FEATURES OF THE BILLS The Senate and House bills contain several important reforms that would encourage the expansion of industry rivalry and benefit consumers in the process: V Elimination of RBOC operating restrictions. Under H.R. 3626 and S. 1822, the Baby Bells are allowed to apply immediately to federal regulators for entry into inter- state interexchange or long-distance nwkets between states, provided certain require- ments are satisfied (outlined below). The version of H.R. 3626 that recently passed the House Judiciary Committee makes an exclusive requirement that in cases dealing with RBOC application for entry into intrastate long-distance and resale markets, the Jus- tice Department and state regulators ibust determine jointly whether the application will be accepted. The Energy and Commerce Committee version does not include this requirement. but instead requires the RBOCs simply to charge their new long-distance affiliates; the same access charges they force other long-distance providers to pay. The Baby Bells also are allowed under H.R. 3626 and S. 1822 to apply for permission to manu equipment through a separate affidiate and build their own nationwide telephone networks. After five years, the Baby Bells may apply for permission to pro- vide alarm monitoring systems. S. 1822 also allows the Bells' cellular operations to ex- tend beyond local boundaries.

Removing these legal barriers would mark the political recognition of what is already occurring naturally - the barriers between local and long-distance telephone services are disappearing. If these legal barriers are removed, integrated, nationwide competi- tion can quickly become a reality. This means companies would be able to devote their fm and resources to direct competition instead of using their creative talents to find ways to circumvent existing regulations. V Elimination of the cable-telco ban. Both H.R. 3636, and S. 1822 would eliminate the most important barrier to the information highway-the "cable-telco ban." As long as they do not violate certain criteria (outlined below), telephone and cable firms would at last be allowed to compete against one another. Removing this legal barrier to competition would help dissolve the governmentally induced monopolies of these firms and ensure that consumers are provided a broader array of services in their homes.

Other beneficial elements of the legislation include:

H.R. 3636 and S. 1822 both mandate a review of the usefulness of broadcast own- ership restrictions, which limit the number of stations broadcasters may own. S. 1822 also requires the PCC to study the usefulness of federal restrictions on the ownership of syndicated programming by broadcasters. Rep. W.J. Tauzin (D-LA) successfully offered an amendment to H.R. 3636 that would allow broadcasters more flexible use of their spectrum allotments. For ex- ample, they could provide messaging or home shopping services over their section of the spectrum. H.R. 3626 and S. 1922 would require that greater attention be focused on user pri- vacy rights as they relate both to the introduction of new technologies and the regu- lations governing the system. It would ensure personal customer information is not divulged by companies without permission. m' H.R. 3636 and S. 1822 prohibit states and municipalities from creating entry barri- ers to local competition. The states and the FCC are also encouraged in the bills to adopt more flexible forms of rate regulation where competitive markets exists, but unfortunately are to retain strict rules for markets deemed to be uncompetitive. Complete rate deregulation would be mom constructive and pro-competitive than continued regulation. UNWELCOME FEATURES OF THE BILLS

Unfortunately, the proposed legislation adds several new restrictions at the same time as it knocks down odw regulatory barriers. Chief among these new and unhelpful restric- tions are: Restrictions on RBOC entry into new markets. Under H.R. 3626, a Baby Bell com- pany would not be able to move ahead with its plans to enter new markets if the gov- ernment finds that the company applying for permission to do so could use its sup- posed monopolistic power to impede competition in that market. Entry would be al- lowed only if the FCC 'TWds that granting such request is consistent with the public interest, convenience, and necessity:'23 Various requirements a firm must meet before entry is allowed include: w' An assurance that rates Will be reduced (especially for residential consumers); w' The demonstration of the firm's ability to deliver new services immediately to consumers; An assurance that the firm Will not be able to use "predatory pricing" tech- niques to undercut competitors,*,

An assurance that monopolistic concentration will not result among firms entering new markets; and An assurance that the FCC will be able to continue to enforce its regula- tions governing alarm monitoring systems. Likewise, under S. 1822,.RBOCs are permitted to enter long-distance markets immedi- ately only if the Bell company concerned faces "actual and demonstrable' competition in its local market and could not use its local market power to impede competition in the long-distance market. Such requirements to allow telcos into each others' markets only after meeting arbi- trary competition tests are self-defeating because they give the firms currently control- Hng the market an opportunity to lobby against the entry of potential rivals. The best way to ensure that vigorous competition develops in these markets is to allow more firms to enter immediately. Currently, legal barriers such as the cable-telco ban and the Baby BeH operating restrictions deny market access to new entrants. These regula- tions must be eliminated if legislators ever hope to see telephone and cable monopo- lies disappear. Yet, the legislation currently before Congress contains numerous tests (specifically for Baby Bell entry into long-distance markets) which will discourage im- mediate competition. Long-distance companies argue such tests are necessary since they feel RBOCs could use their substantial profits from the "access charges" they levy on long-distance providers to finance entry into long-ffistance markets. These access charges to local markets are substantial, representing almost half the cost of providing long-distance service. 24 The long-distance firms hope that within a few years local markets will be- come more competitive, thereby more widely disseminating who receives the access charges and placing the RBOCs on equal footing with the long-distance firms. But this reasoning is flawed since local markets are quickly becoming competitive, thereby diminishing the scope of RBOC power. In addition, the long-distance firms continue to enjoy the advantages of organizing alliances and acquisitions to strengthen their position. Long-distance deals with cellular or other wireless firms, such as AT&T-McCaw merger and the MCI-Nextel deal, could aRow them to bypass the Baby Bells altogether and service customers directly. In the Senate, Senators John Breaux (D-LA) and Bob Packwood OWR) have pro- posed an amendment to S. 1822 that would wisely eliminate such arbitrary and anti- competitive uirements. Their amendment would allow immediate inter- and mtra- state competition for telephone service one year after the bill's enactment. The amend- ment also would require equal regulatory treatment of telephone and cable providers such that a cable firni would not be able to provide telephone service where la. telco is prohibited from providing video services.

Separate affiliate requirements. Even if the Bells pass these tests and gain entry to new markets, all three bills still contain a variety of requirements they must abide by once in those markets. For example, under H.R. 3626 and S. 1822, Baby Bells who wish to manufacture equipment must do so through a separate business affiliate to avoid cross-subsidization of one branch by another. And under H.R. 3636, unless they are a small rural provider of service, telcos wishing to provide video services may do so only through an affiliate to insure they are not able to cross-subsidize video service with profits from telephone service. Similarly, cable operators offering telephone serv- ice must not cross-subsidize that service with their cable profits. Finally, Baby Bells and their existing affiliates may not use their equipment to deliver electronic publish- ing services, such as home on-line financial or shopping services. They must instead establish a separate affiliate or enter into joint ventures to do so, and are not allowed to cross-subsidize other services with profits from those activities. Electronic publish- ing regulations would expire on June 30, 2000. Congressional concerns about cross-subsidization arise from the fact that if a telco were allowed to subsidize service of a deregulated portion of its operations with reve- nues from its regulated business(es), rate payers would be unfairly burdened with costs they are not responsible for. Although there is truth to this fear, the solution is not to continue to require separate affiliates for each new service. Rather, it is to re- form or end rate regulation altogether. Monopolistic concerns and buy-out restrictions. Closely related to fears of cross- subsidization are concerns about monopoly in the legislation. Various restrictions are mcluded in an apparent attempt to curb the development of monopolistic markets. For example, H.R. 3626 would prohibit RBOCs from "tying" the sale of one of its serv- ices to any other product or service for fear it could create monopolistic advantages (that is, they could not require a customer to purchase voice and video services as a package). ShniWly, if an RBOC slowly came to control a market it had entered, pri- vate firms adversely affected by such competition would be able to file a civil suit and be eligible to recover treble damages and attorney's fees. Likewise, H.R. 3636 prohib- its telcos from buying out competirig cable systems within the region they offer serv- ice, although they would be able to own a controlling interest or form a joint venture with those serving rural areas. S. 1822 is even more stringent: cable and telephone companies would be allowed to own only up to 5 percent interest in an existing cable operator in their service area and joint ventures, and partnerships with local cable op- erators would be prohibited. This concern about monopoly is misguided. As mentioned, telecommunication monop- olies traditionally have resulted from extensive and unneeded government regulation which protects dominant carriers, not from any nauiral tendency toward monopoly. Al- though legislators and regulators like to argue that monopolies would have occurred in the absence of regulation anyway, the fact remains that only a regulation approach has been tried; it has stifled competition and actually fostered monopoly. The sections of the proposed legislation allowing competing firms to sue under an antitrust rationale will only cause an avalanche of lawsuits by inefficient firm trying to thwart new com- petitors. Lawmakers should instead recognize that the best defense against monopoly is to make it as easy as possible for new competitors to enter the market.

FEATURES THAT WOULD UNDERCUT DEREGULATION

Finally, the proposed legislation contains two provisions that, if passed, would under- mine one of the main goals of the legislation to promote an innovative, competitive indus- try. They are: Expanded definition of universal service. H.R. 3636 and S. 1822 contain language that, although vague, requires the FCC to ex- pand the definition of universal service from basic telephone service to an as yet unde- fined package of advanced informational services. For example, although not strictly de- fined, H.R. 3636 requires the FCC to establish a "Federal-State Joint Board" that will out- line what basic services telcos must provide to each customer. And S. 1822 would man- date that every service provider contribute resources and services to achieving universal service objectives according to guidelines to be developed by the FCC. These FCC guide- lines would most likely expand the definition of basic service from what is now referred to as "POTS" or "Plain old telephone service," to what many jokingly refer to as "PANS" or "pretty amazing new services." PANS could include anything from simple two-wire voice and video service to the home from different companies to complex technologies such as on-line informational and educational services. The legislation does not specifi- cally outline which services would be included, but undoubtedly it would be more than merely basic telephone service. Although the states would be in charge of implementing these regulations, the FCC could enforce them if they are not carried out properly. Peri- odic FCC reviews would follow passage of the legislation to ensure full service compli- ance by telcos. While the rhetoric of universal service sounds equitable, such requirements in theBast in the case of telephone service has resulted in a government-sanctioned monopoly. Re- quiring communications providers to expand the package of services that every house- hold receives would most likely create an environment most favorable for the industry's largest firms, since only they would be able to provide such a broad range of services. Smaller providers, lacking the economies of scale of larger firms, would be less equipped to provide the services. More important@ legislators ran the risk of creating what hfichael Schrage of The Los Angeles Tirnes refers to as a 'Velfare state ethic in cyberspace.1;26

In addition, mandating broad universal service requirements would require continued oversight by federal and state regulators, encouraging the growth of the very bureaucra- cies that legislators are attempting to eliminate. The Federal-State Joint Board is an exam- ple of such a potentially suffocating new bureaucracy. Real competition does not result from extra "pro-competitive' red tape, regulation, and micro-management. Just as the case of television sets and video cassette recorders illustrates, it is allowing competition, and not mandates, that ensurestonsurners are provided with the services they desire at a reasonable price. Exclusive purchasing and domestic production requirements. H.R. 3626 and S. 1822 would require any manufacturing by the Bell affiliates to be conducted within the United States. Likewise, any parts used in the manufacturing proc- ess by the affiliates must be produced domestically. Affiliates may use foreign-manufac- tured parts only if they cannot purchase domestic products at a reasonable price. Even then, the aggregate cost of foreign parts purchased for use by affiliates must not exceed 40 percent of the annual sales revenue from the sale of that equipment. Penalties may be enforced by the FCC for violations of this provision. Attempts to remove this provision from H.R. 3626 failed in the House Energy and Commerce Committee. In addition, H.R. 3626 permits any competing American manufacturer who feels it has lost business due to an affiliate's illegal use of foreign parts to file suit for recovery of damages. Such domestic production requirements are crude protectionism and would hold back the industry and raise prices for consumers. Legislators seem to fear that once the Baby Bells are given the freedom to manufacture equipment that they will immediately estab- lish their factories overseas to take advantage of cheaper labor. Yet, this is unlikely to be the case. Most manufacturers can be expected to remain in the domestic market to take advantage of the greater technological advantages provided by the highly skilled work force, adjoining industries, and various other educational or engineering institutions. In addition, transportation costs will be higher, and delivery times longer, if firms establish factories overseas, offering an incentive to remain at home. If. despite these advantages, companies turn to overseas suppliers, it is because they produce a superior product for the price. They should not be prohibited from taking advantage of trade in this way. Forcing firnis to produce or procure all or even most of their equipment and parts do- mestically is not how to promote competitiveness and trade deficit reduction. Instead, it discourages improvements in efficiency, and the use of ffie most cost-effective and inno- vative products. thereby foming up pnces and decreasing overall quality of service. At- tempts to pmmote domestic manufacturing in one sector through protectionism requires the movement of workers and resources away from sectors where American firms cur- rently hold competitive advantages over rivals. Hence, firms allocate their resources less efficiently and could lose export advantages they currently hold in high-tech telecom products. For exarnple, domestic production and purchasing requirements might encour- age some providers to refocus their efforts on the production of low-value-added or low- technology products, such as telephone receivers or fax machines, to satisfy the new (but artificially created) market demand. Yet, as Thomas J. Duesterberg of the Washington- based Hudson Institute points out, American producers currently have exporting advan- tages in high-tech high-value-added telecom. equipment such as satellite, cellular, and mi- crowave systems. 7 Therefore, producers might gain some small short-term profits by switching to low-tech industry segments, but could lose out in more important and more profitable high-tech sectors in which they currently hold an exporting advantage. U.S -Trade Representative Mickey Kantor has also pointed out in a letter to Congress that domestic content requirements violate the General Agreement on Tariffs and Trade and the North American Free Trade Agreement. Kantor rightly believes that these protec- tionist provisions would "seriously jeopardize ongoing telecommunications negotiations with the European Union."27 The U.S. has a long-running effort to break down foreign barriers that bar America's high-tech telecom exports, items not fully addressed in the re- cent Uruguay Round GATT Agreement. Establishing domestic barriers when many coun- tries, such as the United Kingdom, are tearing down their own, discourages further gains and invites retaliation.

RECOMMENDATIONS FOR ADDITIONAL ACTION Even if the pending legislation were amended to include the recommendations above, telecommunications deregulation would still be far from complete. And incomplete de- regulation would leave the industry full of numerous inefficiencies that would blunt po- tential competition. For example, failing to deregulate cable or the broadcast industry completely would result in less rivalry being stimulated in those sectors. So traditional providers could remain protected from the entry of new competitors and the information highway might not become a full reality. If Congress and the Clinton Administration truly want the industry to respond to market forces, become innovative, and expand their exporting potential, they should view deregulation mom broadly to include the following steps: I ) Repeal the Cable Consumer Protection and Competition Act of 1992. The Cable Act of 1992 was an unfortunate mistake. In an attempt to restrain rate increases, the FCC promulgated a set of confusing regulations that failed to cut rates to legislatively desired levels. Not surprisingly, the FCC was then forced to make a second round of rate cuts to appease legislative and consumer concerns. As the recently abandoned mergers between Bell Atlantic Corp. and Tele-Communications; Inc., and Southwestern Bell Corp. and Cox Enterprises Corp. Musmft, these rate reductions now threaten to slow the cable industry's ability to participate actively in the building of the information highway by restricting the amount of capital they can re-invest in new ventures. In addition, rate regulation threatens to limit funding of quality cable networks, such as the Arts & " Television Network (A&E), or cut off funding for Proposed channels such as the History channel. As A&E President Nickolas Davatzes says of die regulations, "r1bey] will unquestionably binder the [cable] industry's ability to invest in new technologies and iorparriming and create jobs. Mhe unintended victims of the FCC action are the cable rs, who today find themselves confronting an uncertain and difficult futum."'28 If Congress wants to ensure lower mtes and better service in the long temi, it should repeal the 1992

Cable Act and instead focus on completely deregulating the industry and allowing other communications suppliers to enter the market freely. 2) Create a more flexible spectrum allocation process to ensure the rapid deployment of new technologies. Increasingly, the most vigorous competition within the telecommunication industry is from the wireless communications sector. Cellular, PCS, and other wireless technologies all use electromagnetic waves to transmit voice and data messages that can compete directly with traditional wireline technologies. Yet, these technologies demand large chunks of spectrum space to provide service. Federal spectrum allocation policies typically have been slow to respond to these needs and often allocate the spectrum space poorly. For example, despite the fact that the initial requests for cellular telephone spectrum allocations were made in 1968, it was not until 1981 that the first cellular license was granted. 29 Although the FCC's recent move to reallocate certain frequencies and auction off others for PCS, paging, and messaging services were steps in the right direction, more substantial reforms are needed. To ensure new wireless technologies become vigorous contenders for telecommunication customers, federal spectrum policies must be reformed. First, Congress should require the FCC to adopt a flexible spectrum management policy that would allow those who operate spectrum-based services to use their slice however they wish. Currently firms are required to use their slice only for pre-

About the Author

Show references in this report

1 Robert W. Crandall, After the Breakup.- U.S. Telecommunications in a More Competitive Era (Washington, D.C.: The Brookings Institution, 1991). p. 4 1. (Cambridge, MA:

2 Gerald W. Brock, The Telecommunications industry.- 77w Dynamics of Market Structure Harvard University Press, 1981), P. I I I -

3 Leonard S. Hyman, Richard C. Toole, & Rosemary M. Avellis, "Organization, Development, and Breakup of the Telephone Industry," Industry Briefs. Delran, NJ.: McGraw-Hill, Inc., July 1999, P. 104.

4 5 M4, p. 105-106 [emphasis added].

6 Despite the fha that vigorous competition was encouraging the expansion of telephone service across America, legislators apparently believed rate regulation could spread do benefits of service even faster. Although manipulation of the telephone rate structure probably did encourage rapid dissemination of service, the policy had the added consequence of allowing AT&T to monopolize the entire system since it controlled most long-&tance service. During this same period, moreover, an agreement was rewhed between die government and AT&T known as die "I[ingsbury Commitment," supposedly to rein in AT&rs growing power. instead. the govemment had merely given the firm its blessing to swap local telephone monopolies with independent competit"s and interconnect with them instead of building competing lines. The net result of this action was to discourage direct competition and it led to AT&rs monopoly over the entire industry. Similarly, once the government nationalized the entire radio spectrum in the Radio Act of 1927, any hope of competition via new wireless technologies was crushed. Until the 1980s, the federal goverment used its control of the electromagnetic spectrum to restrict new entrants and protect AM% monopoly status.

7 See David B. Hack, "Cable Television-and Eight Other Contributors to Competition in Multichannel 7V Service," CRS Reportfor Congress, Washington, D.C.: Congressional Research Service, November 3. 1992, p. 3-5.

8 US Indswrfid Outlook 1993, Washington, D.C.: U.S. Department of Commerce, p. 30-10.

9 The equally important flip side is that most cable firms we prohibited from offering local telephone service through both federal and state regulations. Consequently, the leading contender to compete successfully against the Bell System has been prohibited from doing so through government restrictions.

10 David L. Kaserman and John W. Mayo, "Cross-Subsidies in Telecommunications: Roadblocks on the Road to Mom Intelligent Telephone Pricing," Yale Joumal on Regukifim, Vol. 11, (Winter 1994), p. 121.

11 Rate-of-return regulation sets do maximum allowable profit for a telephone company within a business year. Typically, a variation of the famula R = 0 + B(r) has been used to determine the overall revenue requirement (R) a firm needs to earn to stay in business. Regulatory commissions find (R) by estimating what the firm's operating requirements (0), rate base (B), and rate-of-return on investment (r) need to be in order to continue to provide service. Besides the obvious difficulty of conducting ratc-of-return calculations, such a regulatory system is inefficient since firms have little incentive to innovate lacking a profit motive. Price caps generally encourage greater innovation by allowing company profits to fluctuate freely, but instead places an overall limit on the prices they charge customers fbr telephone service.

12 William J. Baurnol and J. Gregory Sidak, Toward Competition in Local Telephony (Cambridge, MA: The Mrr Press, 1994). p. 14-15.

13 See Pew Huber, "Telephones, Competition, and the Candice-Coated Monopoly," Regukaian, No. 2 (1993), p. 34-43.

14 Peter Coy, Robert D. Hof, and James I. Elis, "Ibe Baby Bells' Painful Adolescence," Business Week. October 5,1992,p.124.

15 Such bypass activity is likely to increase if service and rate deregulation is not pursued since companies will continue to se=h for ways to innovate around regulations to satisfy customer needs. Ironically, if this occurs. the same individuals regulators were attempting to help through discriminatory cross-subsidization will be hurt when companies grow dred of the scheme and find a way to avoid it. As David L. Kaserman of AuburnUniversity and John W. Mayo of die University of Tennessee note, "Bypass is a symptom of indficient prices. The longer such prices remain, the more large business customers will choose to escape paying subsidies by circumventing the public network, and the higher die rates will become for customers remaining on the network. Those who claim to champion the cause of small residential customers by definding the current pricing system and downplaying the threat of bypass actually harm those vary customers in the long run." See Kaserman and Mayo, op. cit., p. 138-139.

16 Unfortunately, Judge Harold Greene recently blocked the meW temporarily, arguing dud it runs counter to the MR. The deal could still go ahead if AT&T can prove to Judge Greene that it would not be and-competitive.

17 Cindy Skrzycki, "AT&rs Deal: A Giant Steps Into New Arena," 7he Washington Post, August 22,1993, p. Hl.

18 Edmund L. Andrews, "MCI Plans Big Nextel Stake As a Move IntoWireless." 7he New York 1-unes, March 1. 1994, p. D1.

19 See "Money Goin' Out," 77w Economist, March 5. 1994, p. 78; Kathryn Jones, "MCI Joins Wireless Phone Venture," 7he New York Times, November 18, 1993, p. D5.

20 See "A Year of Turmoil in Communications," 7he New York Times, October 14.1993, p. DI 1; Stephan Kreider Yoder and G. Pascal Zachary, "Digital Media Business Takes Form as a Battle of Complex Alliances," The Wall StreetJournal, July 13,1993. p. Al.

21 ne WEFA Group, Economic Impact of Eliminating the Une-of-Business Restrictions on the Bell Companies, Burlington, MA: The WEFA Group, July 1993.

22 Mid23 H.R. 3626, "Antitmt Reform Act of 1993,"Novemba22,1993, p. 6.

24 Kasem= and Mayo, op. cit., p. 127.

25 As shown by the AT&T example outlined earlier, when governments mampulate raw and control the provision of service, it acts as a disincentive for smaller firms for two reasons. First, only larger firnis typically we able to provide such extensive service. Second, regulators favor monopolies or cartels since they find it easier to control their actions rather than the actions of multiple competitors. Kence6 in die quest to achieve social policy goals, regulatory commissions end up depending upon one, or a handful of firms to provide all the industry's output. Consequently, competition is made difficult, if not impossible. As regulatory economist Alfted F_ Kahn notes, 'When a commission is responsible for do performance of an industry, it is under never completely escapable pressure to protect the health of the companies it regulates, to assure a desirable performance by relying on those monopolistic chosen instruments and its own controls rather than on the unplanned and unplannable forces of competition." Alfied E. Kahn, The Economics offtukdon: Principles and Institutions, Vol. 2: Institutional Issues (Cambridge, MA: Tbe Mrr Press, 1971, 1991), p. 46.

26 Michael Schrage, "Let's Not Put Data Highway On-Ramps on the List of Our Inalienable Rights," 7he Washington Post, January 7, 1994, P. 02.

27 Michael Kantor, Letter to Rep. John D. Dingell and Rep. Edward J. Markey. February 28-1994-

28 Nickolas Davatzes, "Quality Cable at Risk." The Washington Post, April 27,1994, p. A23.