Impact of Government Policies on the Telecommunications Industry

2. Case study 1: AT & T Divestiture

2.1. Goal of this case study:

AT&T provides insight into the effect of regulation and universal service policies on the widespread adoption of plain old telephone system (POTs). In particular, analysis will focus on how AT&T's regulated structure both helped and hindered widespread adoption, the rationale for divestiture and finally the future of basic telephony service following the Telecommunications Act of 1996.

2.2. History of the American Telephone and Telegraph (AT&T) Monopoly

2.2.1. Regulatory Context and Beginnings of a Natural Monopoly

Federal and state regulation of interstate and intrastate telecommunications services on a monopoly basis was embedded in the notion that providing phone services was a natural monopoly. This meant that AT&T could provide phone service to the most people at the lowest cost through one regulated network. This illustrates the idea of a network externality, in which users on the phone network all gain additional utility as the number of users on the same network increases.

AT&T held its original telephone patent by Alexander Graham Bell from 1876-1893. After its expiration, over 6,000 independent phone companies entered to build wireline networks in all parts of the country to provide local telephone service and sell equipment.[1] One early problem customers faced after AT&T's patent expiration in 1893 was in interconnecting customers on competing independent phone companies' networks. As a result, customers were unable to connect to other customers within the same area who were subscribed on competing networks.

President and Founder of AT&T Theodore Vail was a proponent of creating a single natural monopoly in telephony services. AT&T withstood its first antitrust suit in 1913, U.S. v. Western Electric, by establishing the "Kingsbury Commitment." AT&T's Vice-President Nathan Kinsbury wrote a letter to the Attorney General conceding AT&T would stop acquiring independents and provide interconnection to its network for independent carriers. By doing this, AT&T was able to drop the antitrust suit and thus continue acquiring independents. The passage of the Willis-Graham Act in 1921 in Congress reinforced government's partiality to creating a regulated monopoly system. The Act granted mergers among competing telcos to enable the "unification" of service provision.

These early problems illustrated inadequacies in supply and distribution problem under a system of free entry that are traditionally the impetus for regulation. However, whether or not this stemmed from competition or simply from an early lack of interconnection between providers and networks is debatable. Some revisionists would argue that "universal service" was provided by "competition and independent construction, not subsidies, that brought the telephone to rural America."[2] Nevertheless, government regulators moved ahead in 1910 to favor AT&T as the sole provider of telephony services, thus creating a monopoly market structure.

2.2.2. Communications Act of 1934: The Shaping of a Regulated Monopoly

The main impetus driving the Communications Act of 1934 was the goal of providing universal service through (1) the interconnection of networks, (2) standardization in network and equipment technology and (3) maximizing network economies of scale. The Communications Act of 1934 also began federal regulation of communications by forming the Federal Communications Commission (FCC). It is important to note that "universal service" in this sense would imply unifying providers to end fragmentation in phone service and thus enable connectivity between customers.[3] This contrasts with the concept of "universal service" as it exists today as a policy goal to make basic phone service available to as many people as possible as a public good.

Under the 1934 legislation, AT&T was essentially granted immunity from antitrust suits with the goal of providing universal service. At the same time, it was also prohibited from telco-broadcast cross-ownership. This, along with the Willis-Graham Act, effectively gave license for AT&T to complete its acquisition of independent phone companies and ultimately build its empire of Bell operating companies (BOCs).

Not only did AT&T maintain a monopoly in voice service, but also maintained monopoly control of the long distance network and all consumer-attached telephone equipment such as phones and wires. AT&T thrived on this vertically integrated monopoly structure for decades before it became a legal and regulatory obstacle for competitors who wished to provide the non-Bell equipment to customers.

2.2.3. 1956 Consent Decree, Antitrust Suits and Pattern of Deregulation

In 1949, the U.S. Department of Justice (DOJ) charged AT&T with violations of the Sherman Antitrust Act. This case was finally settled by agreement between AT&T and the DOJ in a 1956 Consent Decree. This settlement limited AT&T's business to common-carrier telephony services and prohibited them from entry into the computer industry.

Under its own corporate policy of "foreign attachment restrictions," AT&T engaged in exclusive dealing practices by prohibiting the attachment of equipment or consumer-owned devices not made by itself or its manufacturing subsidiary, Western Electric. These foreign attachment restrictions were justified by AT&T's interest in creating compatibility standards and maintaining reliability of its network. However, several lawsuits followed which challenged AT&T's exclusive dealing practices. In the Hush-A-Phone v. U.S. (1956) case, AT&T lost in its attempt to ban a mouthpiece hushing device on its phones. Similarly, in the Carterphone (1968) decision, the FCC successfully set precedent in ending AT&T's foreign attachment restrictions. In Carterphone, it ruled against AT&T's ban on another company's attachment of a small cordless phone device.

AT&T's ban on various network equipment and devices not made by its own manufacturing subsidiary hindered the use of new and efficient technologies in its provision of phone service. The FCC's decisions began a pattern of incremental deregulation of AT&T's network. AT&T's situation only worsened when inflation in the 1960s led to declining profitability. In response, AT&T delivered poor phone service and maintenance, while trying to reduce its labor costs. Moreover, a growing demand for information services and equipment that AT&T was not able to respond to as a voice-only monopoly provider.

Moreover, one year after Carterphone, AT&T began to face direct competition once MCI was permitted to operate the first competing long distance line. This was particularly a blow to AT&T since MCI did not have to carry the same burden of providing local service. In effect, MCI could take the most profitable long distance customers without having to cross-subsidize these profits to cover the costs of local service. Yet for a long distance call made in the Bell System, "60 to 70 percent of the charges were returned to the local telephone company as a form of subsidy to keep local rates low and to make telephone service affordable."[4] In short, this gave MCI a competitive advantage over AT&T.

Recurrent antitrust suits initiated by the FCC and Justice Department made clear the policy (and political) struggle between protecting AT&T's monopoly structure and its growing market dominance. By the mid to late 1960s, AT&Ts monopoly system became an impediment to (1) competitive entry, (2) providing efficient services to meet growing demands and (3) technology innovation. Various exogenous forces including the increasing pressure of outside competition, inflation, and a growth in demand made manifest the regressive performance of AT&T's monopoly system. The legal battles AT&T fought throughout the 60s culminated in its last antitrust suit in 1974, when the DOJ alleged AT&T was using its monopoly structure to engage in predatory behavior through its exclusive dealing practices and its interconnection charges priced well above costs.

2.3. Divestiture: Culmination of a Series of Events Leading to AT&T's Breakup

2.3.1. The Modification of Final Judgment (MFJ)

In 1982, AT&T finally made an agreement with Justice Harold Greene in the MFJ to settle the case by divesting of its regional operating companies. The MFJ was essentially a modification of the earlier 1956 Consent Decree. The MFJ separated local business from its long distance business by creating a division between intra-LATA (local access and transport area) and inter-LATA exchange areas. AT&T divested itself of its 22 BOCs which subsequently formed 7 regional Bell operating companies (RBOCs). The RBOCs were restricted to intra-LATA service, which meant they were not allowed to carry traffic between LATAs even if the call was within the same state.

Divestiture was ultimately meant to open up the long distance market to competition. However, the RBOCs continued to be regulated as natural local monopolies. The MFJ agreement made several restrictions and requirements on lines of business for both the BOCs and AT&T. Aside from providing intra-LATA service, the BOCs, were mandated to provide all IXCs equal access to its LEC wireline networks. "Equal access" provided switched IXC access so that for each call made could be routed through the LEC Public Switched Telephone Network (PSTN) first and then to the IXC point-of-presence (POP).[5] Other lines of business that the BOCs were permitted to provide included Yellow Pages publications, sale of customer premises equipment, cellular service and ancillary voice service such as voice messaging, storage retrieval and e-mail. At the same time, they were prohibited from providing any other unregulated, non-tariffed service and information services (though this restriction was later removed in 1991 in a Supreme Court case).

On the other hand, the MFJ permitted AT&T's entry into the flourishing computing industry in exchange for divesting itself of its local telephone companies. In many ways, this was in the best interest of AT&T, whose voice-only natural monopoly clearly evinced weaknesses in service and efficiency long before divestiture. Entrance into the computing industry offered AT&T an opportunity for technological innovation, where its regulated monopoly in telephony eventually stifled development. AT&T maintained its manufacturing and research line of business after the MFJ as the RBOCs continued to rely upon AT&T for the purchase of switching equipment. The fact that AT&T was able to keep Western Electric and the Bell Labs raises the question of how effectively divestiture was in breaking AT&T's vertically integrated monopoly. Last year, AT&T spun off its manufacturing/research into a separate entity called Lucent Technologies so that it could re-focus its efforts on local and long distance services now permitted under the Telecommunications Act of 1996.

2.3.2. Effect of divestiture on financial performance of Baby Bells and AT&T.

In 1984, AT&T's net income dwindled to $1.4 billion at a 2.6 profit margin from its pre-divestiture $7.3 billion income and 11.1 percent profit margin.[6] Competitors in the long distance market such as MCI, Sprint and other IXCs had a noticeable increase in their percentage market share between 1985 and 1992, at the same time AT&T experienced a 13 percent drop in their share of the inter-LATA market.[7] All in all, "the value of AT&T and its former subsidiaries has tripled since divestiture"-clearly making apparent the significant impact of regulatory policy on not only market structure, but financial performance.

2.3.3. Was divestiture a good idea?

Although divestiture was key to opening up competition in long distance, perhaps the way the Justice Department decided to break AT&T's monopoly structure could have been done differently. Specifically, by rejecting divestiture of AT&T's vertically integrated structure and by instead choosing to horizontally divest, two different structures were created: one, a "competitive" free-market model and the other, a regulated monopoly. The first was for AT&T and its new opportunities in computing, combined with continued long distance, manufacturing and research labs. The other was the divested Baby Bells into 7 RBOC local monopolies.

Opponents of divestiture would argue AT&T's breakup was a result of politics, rather than a function of its regressive industry structure. Congress had legislation designed to end AT&T's vertical monopoly and cross-subsidized local service. Also, long distance rival MCI persuaded regulators to allow them to enter areas of AT&T's territory, prompting the MFJ. But whether or not the breakup was a result of politics, the result fell short of its intended goals. As Peter Temin points out in The Fall of the Bell System, one of the long term goals that was sacrificed was the misperception that AT&T would be able to compete freely in new, unregulated lines of business. However, one problem with this was that the RBOCs eventually were able to petition the U.S. District Court to get relief from its lines of business restrictions. An example of this was their relief from MFJ restrictions on transmission and production of their own information services in 1987 and 1991. Another issue after divestiture was AT&T's diminished resources to maintain its R&D side and lost economies of scope from no longer being able to vertically integrate the Bell Labs with its BOCs.

Proponents of divestiture would argue breakup happened because of poor performance and/or anti-competitive behavior. This is the traditional view that "big is bad"-that AT&T's regulated monopoly was simply an inefficient way to operate. In particular, its huge system of cross-subsidization that resulted from subsidizing local with long distance created barriers to entry and generally distorted competition in the long distance market. Finally, other proponents would view the continued regulated local monopoly under divestiture as a means for serving the "universal service" policy goal.

2.3.4. Persistence of subsidies

Cross-subsidization persisted even after divestiture in the form of access fees. Both per-line and per-minute fees were charged by the RBOCs at each end of a long distance call completion to the IXCs to cross-subsidize local service constituted a large part of the RBOCs' total revenues. Although access charges are charged to the IXCs, they are implicitly passed on to customers in the form of higher long distance prices. In effect, access fees have created a distortion in the supply and demand of local and long distance calling. Thus, although divestiture effectively broke the vertically integrated monopoly in long distance, it perpetuated a system of implicit subsidization created by the RBOCs' system of local monopolies. Ultimately, the aggregate effect of these subsidies has been a distortion in the costs of providing local and long distance service, which has lasted until now.

Today, the FCC is shifting the burden of subsidization to businesses and residential customers who own more than one line. In recent rulings on phone charges, the FCC has both increased subscriber line charges and per-line access fees on second lines and business lines. At the same time, this is meant to reduce per-minute access fees--estimated at $23 billion--over the next 5 years to offset other charges.[8] The intended effect of reducing customers' long distance fees is yet another attempt at restructuring the telephony services market to enable more competition. In fact, this move is perhaps one of the largest attempts at restructuring the industry through direct regulation of costs/subsidies since divestiture.

2.4. Impact of the Telecommunications Act of 1996 on Telephony Services

In stark contrast to historical regulation of basic telephone carriers, the Telecommunications Act of 1996 sets policy basis for the deregulation of local and long distance markets by requiring interconnection of local and long distance providers. It thus ends the natural monopoly structure of the RBOCs by allowing long distance carriers to provide local service and alternatively, local carriers to provide long distance. By deregulating all lines of business restrictions on telecommunications providers in voice, video and data services, the Act is clearly central to the end of monopoly structures in the provision of communications services.

At the core of the Telecommunication Act of 1996 is the goal of interconnection and open access to networks in both local and long distance. Local competition provisions are being established by state PUCs to ensure incumbent LECs satisfy a checklist of requirements to make their networks accessible at reasonable rates for new entry. This includes resale and unbundled element agreements, access charges and related requirements.

Finally, universal service policies continue to be a compelling policy goal for the FCC and state commissions. The challenge of maintaining universal service goals in a deregulated, competitive market is a significant one. Under the Telecom Act, the creation of Universal Service subsidies under the Universal Service Fund (USF) attempts to make subsidies explicit. The policy goal of universal service is a controversial and political one. It involves coming to a consensus on what should be provided as a "basic service" to all customers, regardless of whether they live in a high cost area or their income level. Also, a huge obstacle that faces the FCC is how to balance the goals of universal service with the goals of eliminating continued regulation in local service.

2.5. Basic Lessons Taken from Regulation and Effects on Technology Adoption and Innovation

Some lessons can be learned from a study of regulation of AT&T's natural monopoly structure. One is that creating a natural monopoly is desirable to enable various network externalities such as interconnection of networks, maximizing economies of scale and standardizing networks. However, although natural monopolies can achieve these various network effects, they are not necessarily the most efficient way of providing telecommunications services. It is precisely at the point when they begin to create barriers to entry and thus stifle innovation that they are clearly no longer viable. In AT&T's case, its restriction of communications services through high interconnection charges and monopoly in vertical services like voice, equipment and R&D, created a regressive and anti-competitive structure. Even though AT&T was able to create a nationwide wireline network, government regulation aimed at protecting its monopoly structure actually contributed to delayed competition, as well as opportunities for innovation in other lines of business.

AT&T's divestiture provides a good example of how government regulators can intervene in the market to identify inefficiencies in the provision of telecommunications services-particularly high fixed cost networks. It also illustrates how (de)regulation can enable expanded opportunities and R&D. In AT&T's case, expansion into the computing industry was one of the few ways it could continue to innovate when its voice-only monopoly proved technologically stagnant. Finally, the deregulatory principles of the Telecommunications Act effectively mitigates the adverse monopoly effects by allowing complete interconnection and equal access to competition among local and long distance providers. Also part of the 1996 Act and recent rules on FCC access charge reform, is the observation that regulation can also identify related market distortions in subsidies and at the same time promote social goals such as universal service.


[1] David J. Atkin, "Local Telephone Services (POTS)," Telephony, 1994.

[2] Milton Mueller, "Myth made law; Telecommunications Act of 1996," Communications of the ACM, Vol. 40, No. 3, March 1997.

[3] Ibid.

[4] A. Michael Noll, Highway of Dreams: A Critical View Along the Information Superhighway, 1997, p. 81.

[5] An inter-LATA call originates from the LEC's end office to one of its access tandems, which in turn provides a switching system to distribute traffic for inter-LATA calls that are originated or terminated in an LEC's LATA.

[6] A. Michael Noll, Highway of Dreams: A Critical View Along the Information Superhighway, 1997, p. 126.

[7] "Telecommunications Services," U.S. Industrial Outlook 1993, U.S. Dept. of Commerce, 1993.

[8] Mark Landler, "Big Restructuring of Phone Charges Approved by FCC," New York Times, Vol. 50,786, A1.