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A theory of regulatory expansion

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Title:
A theory of regulatory expansion the states implement the Telecommunications Act of 1996
Creator:
Baker, Natalie J
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Language:
English
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460 leaves : illustrations ; 28 cm

Subjects

Subjects / Keywords:
Local telephone service -- States -- United States ( lcsh )
Telecommunication policy -- States -- United States ( lcsh )
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bibliography ( marcgt )
theses ( marcgt )
non-fiction ( marcgt )

Notes

Bibliography:
Includes bibliographical references (leaves 432-460).
General Note:
School of Public Affairs
Statement of Responsibility:
by Natalie J. Baker.

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|University of Colorado Denver
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Auraria Library
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All applicable rights reserved by the source institution and holding location.
Resource Identifier:
49630911 ( OCLC )
ocm49630911
Classification:
LD1190.P86 2001d .B34 ( lcc )

Full Text
A THEORY OF REGULATORY EXPANSION: THE STATES IMPLEMENT
THE TELECOMMUNICATIONS ACT OF 1996
by
Natalie J. Baker
B.S., Indiana University, 1969
M.B.A., University of Denver, 1989
M.P.A., University of Colorado, 1996
A thesis submitted to the
University of Colorado at Denver
in partial fulfillment
of the requirements for the degree of
Doctor of Philosophy
Public Affairs
2001
W
m Lf-v
& ji .


This thesis for the Doctor of Philosophy
degree by
Natalie J. Baker
has been approved
by
Ken Gordon
2? tout I
Date


Baker, Natalie J. (Ph.D., Public Affairs)
A Theory of Regulatory Expansion: The States Implement the Telecommunications
Reform Act of 1996.
Thesis directed by Professor Peter deLeon
ABSTRACT
This dissertation is an inductive study drawing on a wide range of published
research and historical evidence of the regulation and deregulation of the last
monopoly in telecommunications in the United States local telephone service.
Although it takes as its specific starting point the Telecommunications Reform Act
of 1996, it places the policy process in the context of economic and technological
advancement generally. In doing so, it emphasizes the cyclical nature of the
relationship between markets and government while also raising questions about the
true state of that relationship today at the sub-national level. The intent is
theoretical; the methods are empirical.
The specific focus of the research is fourteen state utility commissions in the
operating territory of the former U S West Communications now Qwest, Inc., as
they manage the transition from monopoly to competition in the provision of local
exchange services. Under the 1996 Act and the FCC rules that implement it, the
policy directive to the states is clear; replace economic regulation with competition
as the best vehicle for consumer protection.
Findings from quantitative and qualitative analyses indicate that after more
than five years of proceedings, the promise of statutory rhetoric has yet to
materialize for average residential consumers and small businesses. Ironically, the
regulatory apparatus, instead of giving way to competition as intended, appears to
be expanding in one direction and receding in another simultaneously. At once,
new entrants are denied the means to compete even as the incumbent monopolies
gain regulatory relief and are protected from the discipline of the market.
Thus, the empirical question, given the oft-repeated assumption that
telecommunications technologies are important domestic as well as global engines
of economic growth, is why? The need for this and similar studies is particularly
relevant in view of the widespread and quite fundamental disagreement about the
appropriate relationship between markets and government generally and here


specifically where there exists a federal / state "partnership" in the oversight of the
deregulation of the telecommunications industry.
This abstract accurately represents the contents of the candidate's thesis. I
recommend its publication.
Signed
Peter deLeon


DEDICATION
I dedicate this thesis to Professor Peter deLeon for his patience in allowing me to
discover what he already knew.


ACKNOWLEDGEMENTS
This dissertation represents the culmination of a decade of study first
begun in 1991 with one course undertaken as a "special student." From the
outset, the simple self-imposed bargain was to continue as long as it was
worthwhile and enjoyable. Clearly, that condition persisted.
Admittedly, ten years is a long time so I cannot possibly
acknowledge all of those that have influenced and contributed. But, just as
this research project relies on multiple methods and sources of information,
so also are there multiple categories of individuals who are entitled to share
this moment.
First, I wish to express my sincere appreciation for a group of
professors at the University of Colorado Graduate School of Public Affairs
under whom I completed the requisite course work. The sum of their
wisdom, guidance, and experience were a significant motivating factor in the
period leading up to the undertaking of this dissertation. In order of
appearance, they include Dr. Bob Denhardt and his "mother" of all group
projects; Dr. Kathryn Crawford who in a less than delicate manner directed
"your writing needs to improve" she was right and presumably it has; Dr.
Bob Gage who insisted on the transformation of "a bucket of slush" into
intellectual rigor; Dr. Peter deLeon who provided initial exposure to the wit
and wisdom of Mssrs. Lasswell, Merton, and "RD" (more about Dr. deLeon
later); Dr. Franklin James who emphasized that "the goal is to graduate ...
take two classes a semester;" Dr. Mark Pogrebin for whom qualitative
inquiry and humor are compatible with the most serious of field research
endeavors hopefully I haven't fallen short; Dr. Lloyd Burton's wondrous
ability to infuse administrative law with a sense of fascination; Dr. Sam
Overman's keen interest in telecommunications policy; and Dr. Jody
Fitzpatrick to whom I owe redemption from the terror of forever remaining a
statistics blockhead.
Second, with respect to the field research undertaken for this
disseration, there are countless individuals that have participated -- wittingly
and unwittingly colleagues and adversaries informed and otherwise .
Those who knowingly and graciously contributed include Richard Thayer,
Gary Witt, Cathy Brightwell, Deonne Brunning, Eileen Benner, Cynthia Van
Landuyt, Greg Allen, Paul Hartman, Jeff Oxley, Gary Klug, and Sandra
Adams. My interaction with them professionally and for purposes of this


research has been invaluable. Moreover, they are a rarity in an industry
where nowadays exhibiting the courage of one's convictions is not frequently
rewarded. Added to this list are colleagues (present and former) from whom
I also learned much about the workings of the legislative and regulatory
arenas and the subject matters of wireline telecommunications services: Ron
Gayman, Pat Hickey, Tom Berkelman, Pat Parker, Becky deCook, Susan
Proctor, Michael Lieberman, Mark Lemler, Steve Levinson, and Charlotte
Field.
Third, industry consultants, scholars and lawyers that I have had the
good fortune to observe and learn about the art of advocacy as well as
subject matter expertise in telecommunications include Professor John
Mayo, Professor David Kasserman, Professor William Lehr, Joseph Gillan,
Richard Chandler, Dr. Thomas Zepp, Dr. Robert Mercer, Dr. Daniel Kelley,
Dr. Lee Selwyn, Tucker Trautman, Esq., and Robert Nichols, Esq.
Fourth, my committee has been patient very patient -- it took me
nearly two years to formulate the research proposal and three more to
complete the research and writing. Throughout, my chairman, Dr. Peter
deLeon, has been a steadfast source of encouragement, guidance, and
strategically-placed prodding, without which I am certain this would not
have been completed. Drs Gage, Eckard, and Boyd have provided
invaluable feedback, guidance, and instruction at the precise moments and
when most needed to connect the dots. Ken Gordon, the fifth member, is
an exemplary state legislator who is tirelessly committed to the welfare of
the people of Colorado.
Finally, in the category of essential editorial assistance, friends, and
relatives, many thanks to Annett Beck at the Graduate School who provided
assistance through multiple format reviews; Dawn Savage, for keeping me
informed of all deadlines through several semesters of thinking this would
conclude and moral support and unwavering encouragement from my dear
friends Linda Welch and Roger Caughlin. The one that has contributed in
numerous technical and non-technical critical functions is Dick Chandler a
brilliant engineer, editor, and life's partner.


CONTENTS
Figures.................................................... xiv
Tables..................................................... xvi
Preface..................................................... xx
CHAPTER
1. INTRODUCTION................................................... 1
Examining Telecommunications Reform.......................... 3
Defining the Research Problem.......................... 5
The U sual Suspects.................................... 6
Methods of Inquiry........................................... 9
Organization................................................ 10
2. THE DEREGULATION OF LOCAL TELEPHONE SERVICE................... 17
Imperfect Markets........................................... 18
Imperfect Governments....................................... 20
The Pace of Technological Change...................... 20
The Cost of Regulation................................ 21
Bureaucracy........................................... 22
Policy Shift.......................................... 24
viii
The Transitional Market
25


The National Deregulatory Framework.................... 27
Linking the Reforms.......................................... 43
UNEs and Access Reform................................. 43
UNEs and Universal Service............................. 45
Access Reform and Universal Service Reform............. 47
Summary................................................ 49
3. THE TELECOMMUNICATIONS REVOLUTION............................ 55
Tracing the Context of Telecommunications Policy............. 58
Balancing Interests and Preferences.................... 60
Political Eras of Regulation................................. 64
Local Phase I: The Birth of the Bell System and Telephone
Regulation............................................. 66
The Progressive Era.................................... 70
The New Deal Era....................................... 77
The Great Society...................................... 82
Local Phase II: The Laboratory of the States........... 93
The "Great Compromise" of 1996......................... 98
Conclusion................................................... 99
4. DIALOGUE WITH THE LITERATURE...................................106
Policy and Regulation........................................107
Theories of Regulation.......................................110
IX


Public Interest Theory........................................112
Private Interest Theory........................................118
Values, Politics, and Theoretical Backlash.....................126
States As Actors.....................................................130
The Telecommunications Policy Process..........................132
After Divestiture: Theory and Practice of Regulation in the States 139
Theory, Practice, and Policy Sciences..........................141
Identifying Trends and Formulating Propositions......................145
5. METHODS OF INQUIRY.....................................................150
The Strategy for Studying Regulatory Reform...........................150
Conceptual Framework...........................................152
Research Design: Achieving Validity through Triangulation............157
Qualitative Methods............................................158
Quantitative Methods...........................................165
The Data.......................................................168
Data Manipulation and Analysis.................................171
Data Limitations...............................................174
The Selection of States...............................................177
Geopolitical Diversity.........................................182
Institutional Variables........................................183
The Preponderance of Independent Telephone Companies...........184


Prevailing Market Structure Variable
186
6. RESEARCH FINDINGS...................................................191
Proposition 1. The Regulatory Framework is Expanding.............193
Network Sharing and Network Elements......................195
Intra-state Access Charge Reform...........................199
Old World and New World Pricing Distortions...............205
A View of the Competitive Landscape........................209
Summary....................................................218
Proposition 2. Universal Service Has Co-Opted the Policy Process.219
"Affordability" and the "Need" for Subsidy.................220
Social Compact and the "Need" for Subsidy Revealed.........222
Bringing Rural Carriers into the Analysis..................231
Designing New State-Specific Subsidy Mechanisms............241
Summary....................................................245
Proposition 3. The Multiple Advocacy Model Favors Incumbents......247
Multiple Advocacy Defined..................................249
Multiple Advocacy in the Reform Process....................250
Concrete Decision-Making and Other Myths...................258
Summary....................................................267
Proposition 4. State Agency Autonomy and Capacity Are Lacking....269
XI


Political Autonomy......................................269
Agency Capacity.........................................274
Summary.................................................292
7. CONCLUSIONS.....................................................318
Analytical Conclusions........................................320
Propositions 1 and 2: The Paradox of Too Much and Too Little
Regulation..............................................320
Proposition 3: Confirmation of a Bias Toward Incumbents.324
Proposition 4: Confirmation that Agency Autonomy and
Capacity are Lacking....................................328
The Department of Unintended Consequences...............332
Policy Implications...........................................334
Who Do You Trust?.......................................338
Power to the States?....................................341
Policy Prescription.....................................345
Theoretical Implications and Further Inquiry..................347
Regulatory Expansion: Theory, Reality, and Truth..............350
APPENDIX
A. GLOSSARY OF TERMS AND ACRONYMS.............................359
B. STATISTICAL DATA...........................................365
C. ANALYTICAL MAPS............................................385
xii


D. TESTIMONY, COMMISSION ORDERS, DOCKETS, AND
STATUTES....................................406
E. INTERVIEW CONSENT FORMS.....................422
BIBLIOGRAPHY.......................................432
xiii


FIGURES
Figure
2.1 The Competition Trilogy........................................... 28
2.2 Basic Network Elements............................................ 32
5.1 Pre Divestiture Bell System Map...................................179
5.2 Post Divestiture Regional Bell Operating Company Map...............180
5.3 Post 1996 Act RBOC Consolidation Map...............................181
6.1 Rural Carrier Sources of Revenue...................................234
6.2 Fourteen-State Map of Rural Carrier Subsidy Mechanisms.............239
6.3 Fourteen-State Map of New and Existing High Cost Subsidy Mechanisms 242
6.4 Fourteen-State Map of Legislative Intervention Prior to 1996.......272
C. 1 Arizona Study Area Map of Incumbent Local Exchange Carriers........385
C.2 Colorado Study Area Map of Incumbent Local Exchange Carriers.......386
C.3 Idaho Study Area Map of Incumbent Local Exchange Carriers..........388
C.4 Iowa Study Area Map of Incumbent Local Exchange Carriers...........389
C.5 Minnesota Study Area Map of Incumbent Local Exchange Carriers......391
C.6 Montana Study Area Map of Incumbent Local Exchange Carriers........393
C.7 Nebraska Study Area Map of Incumbent Local Exchange Carriers.......394
C.8 New Mexico Study Area Map of Incumbent Local Exchange Carriers.....396
C.9 North Dakota Study Area Map of Incumbent Local Exchange Carriers...397
C. 10 Oregon Study Area Map of Incumbent Local Exchange Carriers........399
C. 11 South Dakota Study Area Map of Incumbent Local Exchange Carriers... 401
C. 12 Utah Study Area Map of Incumbent Local Exchange Carriers..........403
XIV


Figure
C. 13 Washington Study Area Map of Incumbent Local Exchange Carriers.404
C. 14 Wyoming Study Area Map of Incumbent Local Exchange Carriers...405
D. 1 Qwest DSL Advertisement........................................421
XV


TABLES
Table
2.1 Comparison of FCC Loop Cost Proxy for U S West States.............. 31
2.2 Comparison of Intrastate Access Rates.............................. 38
2.3 State and Federal High Cost Support................................ 42
2.4 14 State Comparison of U S West Basic Local Exchange Rates......... 48
3.1 Policy Ideal Types and Degree of Government Control................ 62
3.2 Contextual Map of Local Phase 1.................................... 66
3.3 Telephone Service Regulation in Fourteen States.................... 69
3.4 Contextual Map of the Progressive Era.............................. 70
3.5 Percentage of Return on Net Book Costs of Plant.................... 75
3.6 Contextual Map of the New Deal Era................................. 77
3.7 Contextual Map of the Great Society................................ 82
3.8 Contextual Map of Local Phase II................................... 93
3.9 Comparison of the Oligopoly and Distributed Information Revolutions. 95
3.10 Growth of Federal Universal Service Subsidies...................... 96
4.1 Granger, Progressive, and New Deal Regulatory Ideology.............116
4.2 Jurisdictional Oversight of Telecommunications Services............134
4.3 Typology of Reregulation...........................................138
5.1 Propositions Matrix................................................154
5.2 Regional Holding Companies on February 6, 1996.....................178
5.3 Structure of Fourteen State Public Service Commissions.............183
XVI


Table
5.4 Fourteen State Summary of Public Service Commissions............184
5.5 Independent Telephone Companies Operating in 1996............... 185
6.1 Analytical Framework for the Competition Trilogy................192
6.2 Comparison of U S West's Recurring Wholesale and Retail Rates.....196
6.3 Comparison of U S West's Wholesale and Retail Hook-Up Charges...198
6.4 U S West's Annual Regulated Revenue Net of Access.................201
6.5 Comparison of U S West's Intrastate Exchange Access Unit Cost.....202
6.6 Post-1996 Act Access Reform.....................................204
6.7 Comparison of Inter-Carrier Compensation for Traffic Exchange...207
6.8 Status of UNE-Based Local Competition in Fourteen States........210
6.9 National Status of UNE-Based Local Competition..................211
6.10 US West's Financial Performance as UNE-Based Carrier..............216
6.11 Comparison of U S West's Financial Performance as Monopoly and
UNE-Provider.....................................................217
6.12 Household Penetration Rates for Telephone Service by State........221
6.13 Comparison of Average Revenue and Cost Per Line.................224
6.14 Comparison of Federal High Cost Support by State................225
6.15 Comparison of Pre and Post-Subsidy Revenue Flows................228
6.16 RUS Borrowers in Fourteen States..................................233
6.17 Comparison of End-User Telephone Expenditures...................235
6.18 Comparison of RUS Borrower Operating Revenue and Expense........237
6.19 Comparison of Multiple Advocacy Model in the Initial Post-Act
Arbitrations.....................................................252
6.20 State Initiated Challenges to the FCC's Costing and Pricing Rules.255
xvii


Table
6.21 Change in Commission-Ordered Wholesale Loop Prices............260
6.22 Access Reductions Gained through Bargaining...................262
6.23 Partisan Composition of State Legislatures....................282
6.24 Profile of State Agency Ethics Rules..........................288
B.l Monthly Recurring Rates for Unbundled Network Elements (UNEs).365
B.2 Non-Recurring Hook-Up Charges for UNE-P.......................366
B.3 ARMIS Regulated Revenue Report................................367
B.4 Revenue and Expense Data for Profitability Comparison.........368
B.5 U S West Average Per Line Sources of Revenue ($)..............369
B.6 Arizona Rural Company Revenue and Cost........................370
B.7 Colorado Rural Company Revenue and Cost.......................371
B.8 Idaho Rural Company Revenue and Cost..........................372
B.9 Iowa Rural Company Revenue and Cost...........................373
B. 10 Minnesota Rural Company Revenue and Cost......................374
B. 11 Montana Rural Company Revenue and Cost........................375
B. 12 Nebraska Rural Company Revenue and Cost.......................376
B. 13 North Dakota Rural Company Revenue and Cost...................377
B.14 New Mexico Rural Company Revenue and Cost......................378
B. 15 Oregon Rural Company Revenue and Cost.........................379
B. 16 South Dakota Rural Company Revenue and Cost...................380
B. 17 Utah Rural Company Revenue and Cost...........................381
B. 18 Washington Rural Company Revenue and Cost................... 382
B. 19 Wyoming Rural Company Revenue and Cost........................383
B.20 Fourteen State Comparison of the Deregulation of Ethics........384
xviii


Table
D.l Primary Dockets for Cost/Price of UNEs and Traffic Exchange............406
D.2 Selected Access Reform and Universal Service Dockets...................408
D.3 Pricing Testimony Filed on Behalf of U S West in Fourteen States.......410
D. 4 Participation in Regulatory Proceedings by State......................412
XIX


PREFACE
This is a dissertation, not a mystery novel, so let me start by giving away the
ending. Has the breakthrough concept of the Telecommunications Reform Act of
1996 at least one other choice of provider of local telephone services for average
consumers and small businesses been realized? No. Instead, we are moving in the
direction of a deregulated monopoly for the provision of all telecommunications
services.
The implications for such a state of the world are significant.
Telecommunications are a basic infrastructure industry, providing services that are
regarded as necessities by consumers and virtually all businesses. Access to local
facilities are an essential input into most communications services including, local,
long distance, and Internet in street language voice is the killer application. In
economic terms, a negative "shock" to prospects for competition in local
infrastructure services will be amplified as it reverberates first through
communications equipment and service markets and then through the rest of the
economy that is dependent on our electronic communications infrastructure.
Recognizing that competition has been the cornerstone of U. S.
telecommunications policy for nearly thirty years, one surmises that consumer
choice has enabled us to purchase telephones at every conceivable retail outlet, not
think twice about making long distance calls, and most recently, access the Internet
at increasingly higher speeds. Moreover, the ability to communicate, whether by
voice or data, have become a global, rather than local, even national, phenomenon.
Rapid technological innovation, decliningprices, and higher quality services,
however, are all at risk as a number of factors social economic and political --
xx


converge to produce something unintended, but certainly not unheard of in the
annals of American industrial history. That is, if the political agenda of the
incumbent telephone monopolies bolstered by their allies in the U. S. Congress,
the FCC, state legislatures, and state utility commissions are successful average
consumers and small businesses will not have a choice of provider for any
telecommunications services.
The Telecommunications Reform Act of 1996 and the FCC's rules that
implement it, is a broad, national deregulatory initiative that is intended to be the
last chapter in the march to a folly competitive telecommunications marketplace.
The goal to folly replace economic regulation with competition as the best vehicle
for consumer protection follows on the success of the deregulation of
telecommunications equipment and long distance services. Under the Act and the
FCC's rules, state regulators are charged with managing the transition from
monopoly to competition in the provision of basic local exchange service,
discretionary services, and so-called local toll or intraLATA toll. But, the promise
of statutory rhetoric one stop shopping for a bundle of telecommunications
services among many providers may instead be pre-empted by one-stop
monopoly.
The focus of this dissertation is fourteen state public utility commissions
whose common denominator is the former Regional Bell Operating Company, U S
West Communications, Inc. Although U S West was acquired by Qwest
Communications, the nation's fourth largest long distance carrier, in July, 2000, the
change in corporate identity is of little consequence for this project. The fourteen-
state local network remains the regulated portion of the company, thus the services
it provisions remain subject to the 1996 federal Act, the FCC's rules, and their
respective public service commissions. It is these fourteen commissions not U S
XXI


West, Qwest, or any other private concern -- that is the primary focus of this
dissertation.
Throughout the course of this research project, I have been employed by
AT&T as it seeks to re-enter the local telephone market. I have been an advocate on
behalf of AT&T and other new entrants in the market opening and reform
proceedings before these fourteen state public service/utility commissions.
Specifically: I have testified on behalf of AT&T in arbitrations and related cost
dockets that establish the rates for unbundled network elements and the
interconnection of networks; I have served as a subject matter expert in the area of
universal service; and I have testified in all matters related to the reform of the
carrier access pricing regime. At this juncture, I am in the midst of managing the
joint case for AT&T, WorldCom and XO Communications in multiple-state cost
proceedings related to U S West/Qwest's re-entry into the in-region interLATA toll
market under the provisions of sections 271 and 272 of the 1996 Act.
Because I was "acquired" by AT&T concurrent with its acquisition of McCaw
Cellular Communications in 1995,1 began this journey with little prior experience
in the regulatory arena. The opportunity for this project arose coincident with the
passage of the Federal Act in 1996, my then-new position of Senior Analyst /
Witness with AT&T, the mother ship, and the necessity for a dissertation research
project to complete my studies at the University of Colorado. The opportunity was
to conduct an inductive study into what appeared to be essentially uncharted
territory predicated on what appeared a monumental shift in telecommunications
policy and what could be better than as a participant observer? As it turns out,
the "participant" part is far easier than is the "observer" part, but most difficult of all
is separation of the two.
At the outset, I had the notion that society is better off with competition in
this sector and that it would, in fact, replace regulation more of one necessarily
XXII


equals less of the of the other. After all, telephones per se don't harm people and the
amorality of the market is for other categories of governmental concerns like a
tainted food supply, tobacco, gun control, and the like. Wrong. Through this
experience, I have come to understand all too well that the relationship between
markets and government overseen by our federal system of government, is a
delicate balance increasingly in need of technical expertise but also increasingly
attended to by a blunt political instrument public utility regulation. Furthermore,
one underestimates the mischief that is present in the intersection of the public /
private space to one's detriment. And, telecommunications is not excepted. As a
result, telecommunication policy cannot be isolated from the political infirmities
facing any and all socio-economic issues in the current political milieu.
My own advocacy on behalf of AT&T notwithstanding, I have made a
painstaking effort to eliminate as much bias as possible by allowing the data and the
literature to lead where they may a task I discovered to be much easier once one
really grasps the lessons and wisdom history offers. Nonetheless, the conclusions
are my own and are not necessarily consistent with those of AT&T or any other
party to these proceedings. That said, we begin.
xxm


CHAPTER 1
INTRODUCTION
"At this point the whole paradigm has shifted" ... [t]his word paradigm
absolutely drove him up the wall... the damned word meant nothing at all,
near as he could make out, and yet it was always "shifting," whatever it was
In fact, that was the only thing the "paradigm" ever seemed to do. It only
shifted. But he didn't have the energy for another discussion with Wismer
Stroock about technogeekspeak. So all he said was: "Okay, the paradigm
has shifted. Which means what?"
A Man in Full
Tom Wolfe, 1998
What is the appropriate relationship between markets and governments?
Given the rhetoric associated with market liberalization and the rise of more
democratic governments world-wide, many discussions of public policy nowadays
turn on this question (see, for example, Dahl, 1999). Accordingly, most economics
and some public administration textbooks teach that a great many buyers and sellers,
perfect information, homogeneous goods and a complete set of markets, beget
perfect competition bringing "efficiency", thus "equity" in its wake (Crook, 1998).
But, if any of these conditions is missing, the whole normative structure collapses
and massive inequity is likely to occur. There will be market failure, and the desired
results will not materialize regardless of how inefficient or unjust the condition may
be. In the past, these conditions seem that they were all that was needed to justify
government intervention.
1


This line of reasoning, however, is seriously flawed. Market failure in the
sense just defined is not merely common, but universal because the textbook
conditions defining the "perfect market" are never fully satisfied, nor can they be.1
This is not, however, a helpful observation for policy scientists or policy analysts.
What matters, is to know whether, in practice, imperfect markets work better than
imperfect governments (see, for example, Wolf, 1987). That is, in practice, do
competition, incentives rewarding innovation, and survival of the fittest in the
marketplace however flawed that market may be work better than bureaucrats
supposedly pursuing the public interest?
In response to the reputedly high costs of government intervention into the
economic life of its citizens, broad-scale privatization of the so-called infrastructure
industries (e.g., transportation, telecommunications, banking/fmance) is occurring in
the former Soviet Union, Eastern Europe, China, Western Europe, Asia, Latin
America and Africa. In the United States, a parallel process, one as far-reaching but
less well understood, is a dismantling of the sixty-year-old regime of political and
economic regulation in, among others, telecommunications. The political objective
is to move away from government control as a substitute for the market and toward
reliance on private sector competition in the marketplace as a more efficient, thus
equitable, way to protect the public good. Where the demarcation between the state
and the market should be drawn, however, is not a matter than can be settled once
and for all; instead, it is the subject of continuing intellectual and political debate.
Yergin and Stanislaw (1989) argue that judgment awaits the outcome of a two-part
test. The first part, economic success, is easily measured using national income
data. The second part is fiendishly difficult to measure: it is the basic values by
which people judge the world in which they live. Both parts of this test exist in the
context of a modern political complication in the relationship between markets and
2


government a tendency on the part of the electorate to desire more regulation
individually (i.e., transfer payments and entitlements such as social security) while
abhorring it collectively.2 According to Hills (1991), this tendency is the outcome
of an electorate that simultaneously holds governments responsible for the health of
the collective economy and the individual welfare of its citizens.
Examining Telecommunications Reform
Calling on the most recent policy shift in U.S. economic regulation, the
Telecommunications Reform Act of 1996 (the Act),3 this dissertation contributes to
our understanding of how political-economic institutions at the individual state level
shape policy choices and likewise how these choices reshape the institutions
involved. An inquiry into implementation of the key reform policies contained in
the Act (in particular, those mandating the end of monopoly in the provision of local
telephone service) by state utility commissions is well suited to a comparative study
among states for several reasons.
First, the federal statute mandates the removal of all statutory, regulatory,
economic and operational impediments to competition within the same time
constraints, thus allowing for analysis of how state commissions react to similar
economic and political pressures.4
Second, the opportunity to observe a real-time experiment in federalism
has arisen due to the decentralized, yet overlapping, jurisdictional regimes
surrounding the oversight of telephone service. Both federal and state commissions
regulate telephone service, traditionally provided over the unitary public switched
network, but increasingly over a "network of networks."5
3


Third, proceedings at the state level enable an exploration of the interaction
between national economic / political pressures and state politics. This dynamic
allows us to gain a better understanding of the circumstances under which national
pressure is powerful enough to override state political prerogative, or conversely,
those areas in which federalism permits states to trump federal prerogative.
Fourth, a focus on public, rather than private, actors is preferable because it
is bounded. The imprimatur of state commission decisions on policy outcomes may
be more evident than those of the myriad of private interests who are free to move in
and out of the formal administrative process at will. In addition, the preferences of
state actors are too important to ignore because reformulation of policy
implementation mechanisms affects the very ability of state actors to perform their
functions (Vogel, 1998).
Finally, the rhetoric associated with market liberalization, deregulation, and
its sibling, globalization, does not differentiate between the process of market
liberalization between nations and that occurring within nations. Sector market
liberalization between nations is governed by an entirely different set of political,
economic, social, and legal constraints than exists within a single political system.
Telecommunications is a "globalized" industry. Indeed, current wisdom suggests it
is a major catalyst in the globalization of other industries, for example, financial
markets. Accordingly one might conclude that market liberalization at home is a
foregone conclusion. Au contraire, at home the struggle to open up the last bastion
of telecommunications monopoly local telephone service to competition is at
once fierce, interminably slow, and in terms of social welfare expensive.
Moreover, after almost thirty years of a policy of trust in competition as the
preferred vehicle for protection of consumer welfare, the unintended consequence of
the last chapter in the reform process re-monopolization of the entire
4


telecommunications industry maybe at hand. As a result, there is uncertainty
about whether consumers will be faced with two non-optimal "solutions" -- the
prospect of unregulated monopoly on the one hand or a return to strict utility
regulation on the other.6
Defining the Research Problem
The 1996 Act mandates that regulators promote competition and reduce
regulation in the provision of local telephone service. Toward that end, the Federal
Communications Commission (FCC) articulated a national deregulatory framework
for local telephone service via a trilogy of reforms.7 Prophetically, the general
thrust of the question posed by former FCC Chief Economist Farrell (1997) is: How
do we get to deregulate without re-monopolizing? After more than five years of
rule-makings, negotiation, arbitration, litigation, and judicial review of agency
decisions, the regulatory framework at the state level appears to be expanding not
only in terms of the absolute number of new rules and regulations, but also in the
scope and direction of regulation. Instead of receding, state utility commissions
appear to have cast their nets far and wide, seemingly constraining both incumbents
and new entrants.
At the end of the day, despite the statutory mandate of the
Telecommunications Act of 1996 "to promote competition,"8 one observation stands
above all others when it comes to judging the competitiveness of the
telecommunications services markets: consumers do enjoy choices for long distance,
internet, wireless and cable. With the exception of a few large business users in the
major metropolitan areas, however, they cannot avail themselves of the benefits of


competition for local exchange service.9 The empirical question is why? Once
revealed, policy options can and should specify what conditions are necessary to
turn the promise of rhetoric into reality.
The Usual Suspects
The critical question underlying these issues is: To what extent are private
interests served by government regulation? Or alternatively, to what extent is the
consumer well served by government regulation? It is tempting to argue that
telecommunications policy has been captured by lawyers and lobbyists. The former
aim to win cases and the latter seek concessions from lawmakers and regulators;
both thrive on strategic confrontations10 and neither appears to sense the
complexity of the architecture of telecommunications policy. Increasingly, these
entities are highly rewarded for retarding the development of competition rather
than for seeking market-based solutions to stimulate competition.
For their part, state regulators and their staffs have been imbued with a false
sense of moral authority for the publics interest under the assumption that some
grand unified theory of the "public interest" not only exists, but reflects reality. This
notion of the public interest, however, is inherently vacuous in an industry that is no
longer viewed as a natural monopoly, nor is it one in which a scarcity of capacity
(owing to technological advances) can be argued with any seriousness. Nonetheless,
regulators (and lobbyists, lawyers and, lest we forget, legislators) love this idea of
public interest because it is elastic enough and arbitrary enough to stop any
deregulatory initiative that threatens to end the business of regulation-as-usual. In
telecommunications, the universal service imperative fits this agenda perfectly.11
6


Without continuing and expanded regulatory oversight, the argument goes, local
rates in some communities will increase overnight from say, $14.95 per residential
line per month to $500 per month and, besides that, a great digital divide will
descend over the nation.12
Economists, armed with engineering cost models, are the technical experts.
Just as all sides have lawyers, so also do they have economists. Far from informing
the debate with data characterized by neutral competence (Williams, 1994,22), a
dueling experts phenomenon (Smith, 1992, 65) leaves even the best-intentioned
policy-maker not much better informed than before the proceedings began. Not
surprisingly, an economists prognosis of the transition from monopoly to a
competitive market focuses on economic factors that shape the process. How many
new entrants are there? What percent of the market have these new entrants
captured from the incumbents? How many states have adopted and applied with
fidelity the forward-looking economic costing principles mandated by the FCCs
Orders? Indeed, how many states after five years of proceedings have completed
all of the three key reforms set forth by the FCC that enable the national
deregulatory strategy to work?
Although preliminary analysis of the economic factors shaping the transition
provides the evidentiary basis for the observation that the regulatory framework is
growing, this approach alone is incomplete. It does little to explain why more
regulation is occurring at a time when a retreat of the state is presumed essential to
consumer welfare. Moreover, it does little to explain the effects of other political
influences that have invaded the space once left to the "expert agency."
And, as Kenneth Burke reminds us, a way of seeing is also a way of not seeing.13
Economics, as commonly practiced, devotes most of its attention to explaining the
behavior of consumers, workers and firms but precious little attention to that of the
7


other main actor in economic life: government.14 The disciplines normative
preoccupation with the role of government in the economy tends to be dichotomous.
Either conditions of market failure are addressed in a welfare economics framework
or conditions of government failure are addressed calling on a pure hidden hand
(laissez fare) approach.15
Given the economic, technical, social, and political realities of the day, the
traditional organizing frameworks of economics are unlikely to work in practice to
achieve the deregulation of local telephone service. Most of the justification for
economic regulation under the welfare economics framework has evaporated with,
among other things, the inability of regulators (along with everyone else) to keep up
with either the speed or complexity associated with technological change. On the
other hand, a pure hidden hand approach flies in the face of the popular desire for
some degree of redistribution (read: regulation) to ensure that basic telephone
service remains affordable while access to advanced telecommunications and
information services is assured.16
Finally, there is the administrative process. Indeed, the reform of regulatory
procedure has been on the "to-do" list of every administration, Congress, and many
state houses for the past twenty-plus years. While it is evident that no industrialized
democracy does or could operate without a substantial regulatory state,
administrative procedures per se are not the cause of increased regulation. They can
and do, however, provide convenient cover for indecision, inability, and delay. The
promulgation of new rules by the states governing the transition to competition in
local telephone service does contribute to the fundamental disagreement about the
proper mix of government and market.
Although there has been no paucity of procedural delay in this deregulatory
process, the state commissions are no less the perpetrator than any other affected
8


party, including the FCC and the federal judiciary.17 This, according to James E.
Anderson (1998, 476) raises a question of political morality: Is it right or
appropriate to cripple substantive policies by procedural ploys? Although it is not
the intent of this thesis to answer that question directly, policy analysis, prescription
and future research requires that such behavior be taken into account.
The list of "usual suspects" does not pay nearly enough attention to the
possibility that a reordering of government control is essential for this transition.
Accordingly, the state agency (and its interests) should be brought into the analysis
both as an actor and as an institution.18 State utility commissions are, after all,
political bodies that are called upon to render economic decisions (Caudil, et al,
1993). Without the necessary incentives for govemment-the-actor coupled with the
political autonomy necessary to effect reform, govemment-the-institution is unlikely
to achieve the desired policy outcomes. One consequence of this political standoff
is that it contributes to the growing cynicism surrounding the fidelity of
representative democracy in the United States (Nye, et al., 1997). Thus, any theory
that purports to describe and explain government behavior must be focused squarely
on politics grounded in multiple disciplines as opposed to the methodological bias
of a single discipline as a determinant of state behavior. To do otherwise, will
surely produce wrong answers to right-minded questions.
Methods of Inquiry
The fundamental purpose of this research is theoretical; the methods are
empirical. It is well understood that the relationship between truth and science in
9


the conduct of a policy study demands the attention of multiple disciplines, a
problem-in-context orientation and an explicitly normative perspective. These
characteristics, when combined in a mutually reinforcing manner, comprise the
policy-sciences-of-democracy framework (Lasswell, 1971; Torgerson, 1985;
deLeon, 1988). Given the economic, technological, social, and political puzzle
confronted by this study, the policy sciences framework offers the best hope for the
reconciliation of theory and practice in the manner described above.
Accordingly, this inquiry avoids an all-encompassing deductive theoretical
framework and instead proceeds in the tradition of analytic induction, defined as
an approach that draws research questions, concepts and causal hypotheses from a
variety of existing theoretical debates (Evans, Reuschemeyer and Skocpol 1985,
348). Here especially, such questions, concepts, and causal hypotheses are drawn
from the juxtaposition of positivist explanations of regulation embedded in
mircoeconomics and propositions drawn from theoretical work that sets forth an
agenda for government intervention that acknowledges political debate and its
outcomes intended and otherwise. These ideas are then compared through
comparative and historical research.
Organization
This dissertation proceeds in seven chapters. Following this Introduction,
Chapter 2 combines a review of selected literature devoted to specific policy
recommendations, within the telecommunications institutional framework (e.g
theories of pricing, costing, and subsidy) with an explanation of the trilogy of
reforms contemplated by the 1996 Act and the relevant FCC Orders. It provides the
10


legal / regulatory / economic / technological strategy mandated for state
implementation as state agencies proceed to deregulate local exchange services.
Chapter 3 is a "telecommunications policy" chapter in that provides an historical
review of the relationship between government and telecommunications markets in
the United States, tracing the evolution of plain old telephone service (POTS) into
the advanced telecommunications and information services that characterize todays
communications industry.
Chapter 4 is the requisite review of the literature. In as much as this
dissertation is inductive, the literature review is basically unending. Traditional
theories of regulation traverse several disciplines and are, most significantly, time-
sensitive. Heretofore accepted explanations of the infirmities of economic
regulation are questioned. Regulatory impediments notwithstanding, the
technological imperative has provided for competition via unregulated technologies
that allow increasingly for by-pass of and substitution for the public switched
network, a vast public resource that is privately owned but paid for by captive rate
payers via regulated rate structures. A distinct body of sociological work that
provides clues regarding the behavior of the state as an actor in this story is
consulted. Moreover, policy literature continually reminds us that modern social
problems are messy, requiring attention to multiple dimensions all within the
context of democratic principles. Thereafter, theoretical perspectives from political
science, business administration, economics, and law suggest that there needs to be
some reconciliation between the government and market such that redistribution,
free markets and democracy coexist. The question for these scholars is: What
calculus produces the right combination of imperfect markets and imperfect
government?
ll


The next two chapters provide specifics about the conduct of the inquiry.
Chapter 5 sets forth the methods used to conduct the study, including (a) the
rationale for the field sites selected for the research; (b) a description of the primary
and secondary data deemed necessary to provide the evidentiary basis for the
propositions; and (c) the qualitative and quantitative methods used to manipulate the
data. Chapter 6 presents the analytically-derived findings and preliminary
conclusions of the research. In particular, it describes, largely quantitatively, the
state of the world in which potential new entrants now find themselves in these
fourteen states. Additionally, the extent and direction of the expansion of regulatory
framework is described and provides some explanation for this phenomenon and
what difference it makes.
Chapter 7 provides conclusions, practical implications, and policy
prescription. To be useful, policy prescription must free itself first from revisionist
history; second from methods that are myopic; and third from assuming away
important real-life conditions where self-interested elected officials are increasingly
involved in the technicalities, once the purview of independent regulatory agencies,
of political-economic decision-making.
The lessons of studies such as this may help point policy scholars and those
who must implement policy changes in new directions not toward an exclusive
reliance on private markets or government intervention but toward studies that
incorporate an understanding of market forces, promote the democratic character of
modem government, and increase international competitiveness while minimizing
undesirable side effects and reducing regulatory costs.19
Finally, the language of telecommunications requires familiarity with and
reliance on acronyms and a linguistic shorthand derived from technical, financial
and/ or idiomatic expression. For the uninitiated, this lingo might as well be a
12


foreign language. For example -- the phrase "telephone service" as is commonly
used by consumers is too imprecise for this research. We must distinguish between
Plain Old Telephone Service (POTS or basic local exchange service); toll services
that are both local and "long distance" due to regulatory and legal mandates
(generally, LD, interstate, or interLATA toll, local toll or intrastate toll); and
recently, the combination of voice and data requires familiarity of so-called
advanced services such as integrated subscriber digital line (ISDN) and
asynchronous digital subscriber line (ADSL). What consumers refer to as a phone
line is more specifically an "access line", "copper pair", or "twisted pair". In an
effort to assist the reader, a glossary of acronyms is provided as Appendix A.
Unless already familiar with telephone "tech talk," one is advised to keep this at
hand.
13


NOTES
1 Except for those obsessed with efficiency above all else, it is a myth that all economic decisions
are made with mathematical precision and perfect knowledge. Economists, just like the rest of us,
have a garage full of sub-optimal purchasing decisions. See also, Amati Etzioni (1988) The Moral
Dimension. NY: The Free Press.
2 Most recently, a June, 2000 NPR/Kaiser/Kennedy School Poll of found that in general, while
American's tend to distrust government, they also want more government involvement and
government regulation to solve the nation's problems. The results of this telephone survey can be
located on line at: www.npr.org/programs/specials/poll/govt/summary.html.
3 The general purpose of the Telecommunications Reform Act of 1996 is to promote competition
and reduce regulation in order to secure lower prices and higher quality telecommunications services
for American telecommunications consumers and to promote the rapid deployment of new
technologies. Pub.L.No.104-104, 110 Stat. 56, 47 U.S.C. § 151, etseq.
4 U.S.C. 47 sections 252(a) and 252(b) set forth strict timelines for the negotiation, arbitration and
establishment of interconnection agreements (i.e, private party contract) between incumbents and
new entrants for sharing of the public switched network. U.S.C. 47 section 253 mandates the
removal of barriers to entry. Section 253(a) states [n]o state or local statute or regulation, or other
state or local requirement, may prohibit or have the effect of prohibiting the ability of any entity to
provide any interstate or intrastate telecommunications service.
5 The break-up of the Bell system in 1984 resulted in three layers of regulation of telephone service.
The FCC retained oversight for long distance service. The state commissions retained jurisdiction
for local services. Federal District Court Judge Harold Greene retained enforcement authority over
the Modified Final Judgement (MFJ). The MFJ maintained the legal separation of services
provisioned over the same physical network that existed before the break-up. The 1996 Act
removed one layer of regulatory complexity The MFJ and with it, Federal District Court Judge
Harold Greene.
6 As this project concludes, Congress is debating the Tauzin-Dingell Bill that seeks premature
"deregulation" of the FCC's national reform strategy described in Chapter 2.
7 Before the Federal Communications Commission. In the Matter of the Implementation of the Local
competition Provisions of the Telecommunications Act of 1996. CC Docket No. 96-98. FCC Order
96-325, rel., August 8, 1996. § 6-9. (Local competition Order).
8 Telecommunications Act of 1996, Pub.L.No. 104-104, 110 Stat. 56,47 U.S.C. § 151, et seq.
14


9
This proposition is easily proven do you today have a choice for your basic residential local
telephone service? Does your neighbor? Does anyone you know? Thank you. Your participation in
this survey is greatly appreciated.
10 Phrase strategic confrontation borrowed from The Folly of Fair Trade by Jagdish Bhagwati,
in The Wall Street Journal, 11 March 1999.
11 Universal service is the so-called social compact between a monopoly provider and the regulator
whereby in exchange for a guaranteed rate of return and legal protection from competition, the
monopoly has an obligation to serve all who seek service. Under the Telecommunications Act of
1934, there is no explicit mention of universal service, however, it is implied to mean nationwide
deployment of the telephone network. Between 1934 and 1996, universal has undergone a political
transformation such that it has become an entitlement to basic service at 'affordable rates. Under
regulation, affordability has been achieved by shifting costs from residential to business ratepayers,
from rural to urban ratepayers and from local to long distance consumers.
12 In February 1999, Denver Center for the New West held a conference in Washington D.C. entitled
Americas Growing Digital Divide: Causes, Consequences and Solutions. The stated reason for
the conference was [t]he two-tiered society of information haves and have-nots is now a reality.
Even more disturbing, the digital divide is growing(emphasis added).
13 Merton (1987, 9)
14 The notable exception is the Public Choice school. Theorists of this tradition are addressed in
Chapter 4.
15 Welfare economics refers to the belief in the capability of state intervention to secure both socially
desirable economic re-distributions and general economic efficiency. These theories are generally
justified by some reference to the public interest. Public choice theory sees no redeeming qualities in
government intervention into the economy as long as the rule of law provides for private property.
16 47 U.S.C. § 254 (b)(l-2).
17 More than one half of the state commissions joined with the largest incumbent local exchange
carriers seeking to have the FCCs pricing and costing provisions overturned on jurisdictional
grounds by the 8th Circuit Court of Appeals. Having recently lost this battle at the Supreme Court,
they are now seeking to have the same provisions overturned arguing the merits of the FCCs cost
methodology. AT&T Corp. et al. v. Iowa Utilities Board et al. Nos. 97-826, 97-829, 97-830, 97-
831, 97-1075, 97-1087, 97-1099, and 97-1141. United States Supreme Court. January 25, 1999.
18 In descending order, from a thirty thousand foot view to landing, my approach builds on the
extensive literature on the state and national variations in the institutions of economic policy
generally (see, for example, Evans et al., 1985); to telecommunications globally (see, for example,
Vogel, 1996); to telecommunications nationally (see, for example, Derthick & Quirk, 1985);and,
finally, to state level public utility agencies (see, for example, Stone, 1991).
15


19 What the Economist (1999) refers to as a touch of the third way syndrome not this, not that,
but something quite new and wonderful.
16


CHAPTER 2
THE DEREGULATION OF LOCAL TELEPHONE SERVICE
The purpose of this chapter is to begin to align themes in the literature with
the two poles of domestic policy responses to the "monopoly problem" in
telecommunications. Those two discrete policy responses are "regulation,"
embodied in the Communications Act of 1934, and its policy antithesis,
"deregulation," contemplated by the federal Telecommunications Act of 1996, some
sixty-two years later. In doing so, the genesis and evolution of domestic
telecommunications policy, spanning more than 125 years, is deferred temporarily
to Chapter 3.
The ideas that underpin regulation as the policy prescription for another idea,
"market failure," and deregulation as the policy prescription for "government
failure," are discussed under the first two sub-headings. Justification for the
regulation of telecommunications is reviewed under "Imperfect Markets" and that
for the general retreat from regulation in telecommunications under "Imperfect
Governments." Thereafter, the remainder of the chapter is devoted to the national
strategy for the deregulation of local telephony or the transition from monopoly to
competition is under the heading "The Transitional Market."1
17


Imperfect Markets
The economic justification for the regulation of telecommunications is
"market failure." Market failure occurs under conditions of externality, public
goods, information asymmetry, and / or natural monopoly (see, for example,
Scherer, 1970; Weimer and Vining, 1986). Regulation of local telephone service,
deemed a natural monopoly, occurs because, in the jargon of economics, the fixed
cost of providing the service is high relative to the variable cost, so that average cost
declines over the relevant range of demand. Further, it is the price elasticity of
demand that directs policy implications (Weimer and Vining, 1986, 62-63). Under
this theory, the public interest is served because one supplier can produce a good or
service, at every level of output, of both higher quality and lower price (more
efficiently) than can the competitive market.
In general, the focus of economic regulation is market entry, rates and the
common law doctrine of the obligation to serve (Robinson, et al., 1986; Horwitz,
1989; MacAvoy, 1995). In theory, the task of the regulator is to ensure that the
monopoly provider, with its economies of scale and scope, behaves as though the
firm were operating in a perfectly competitive market no more, no less (Baumol
and Sidek, 1994, 5). Thus, regulation serves as the monopolists' "market" and in
accordance with the 1934 Communications Act, the regulator had to manage a
complex combination of non-competitive, service-oriented and artificially stabilized
prices. They were non-competitive in that the regulated firm had market power.
But if the firm did not then subsidize services in some markets, the regulator had to
restrict competing services to raise prices in other markets. This was done by
holding supply at monopolistic levels to the extent necessary to generate enough
18


excess profits to provide the required subsidies. There had to be cash flow from
^
high-priced services (i. e., toll, discretionary services) to extend supply to fringe
consumers, to have available so far as possible to all the people of the United
States a rapid, efficient, nationwide service.3
During times of high inflation, such as that occurring in the late 1960s and
1970s, these same prices had to be held stable. Achievement of this balancing act
required elaborate systems of management by regulators and industry. When that
system broke down due primarily to changing market structure and technological
progress, so did regulation. A new political consensus determined that prices could
not be stabilized by regulation. Furthermore, while cross-subsidization was to be
achieved, it could not be contained as more groups sought to be the subsidized
rather than the subsidizer. The limit of tolerance for this system was the monopoly
price, with maximum transfer payments to impacted classes of customers, fixed
over decades without consideration of new products or services nibbling away at the
edges of the market (MacAvoy, 1995).
As a result, economic ideal set forth by Baumol and Sidek (1994) has, in
practice, consistently been violated. In reality, monopoly rate structure is based on
the revenue requirements established to achieve a prescribed rate of return for the
company which, in turn, leads to end-user rates that are set above costs for some
services in order to provide for the subsidization of others (Kahn, 1970, 1984;
Noam, 1992; Kennedy, 1994). Moreover, the rate-of return regime used for
purposes of price control by regulators has been found to provide the regulated firm
with perverse incentives such that operation at a loss in some markets provides a
convenient mechanism through which certain activities of the firm judged to be in
the public interest can be subsidized (Averch and Johnson, 1962, 1068). The
most notable example of this in the decades preceding the 1996 Reform Act is basic
local exchange service, as we shall see.
19


Imperfect Govemment(s)
Multiple perspectives exist in which to examine the infirmities of
government regulation; three that converge to dominate the institutional framework
of telecommunications include rapid technological change, the inefficiencies
inherent in so-called economic regulation, and the immortality of the bureaucracy.
Each of these is summarized briefly.
The Pace of Technological Change
The dominant view as to why regulation has out-lived its usefulness in
telecommunications comprises the notion(s) of speed and technological change.
That is, technological advancement in telecommunications occurs at such a rapid
rate that it has impeded the ability of regulators to keep up (see, for example, Pitsch,
1996; Drake, 1995; Vietor, 1994). A related theme in this explanation is the
convergence argument. Generally, this argument holds that computing (a non-
regulated industry) is expanded by and, in turn, expands telecommunications; the
Internet is the prototypical example. Neither of these explanations, however, is
new. Partly in response to the rise of the global economy and with it, the perceived
need for global competitiveness, the resurrection of earlier objections to regulation
overshadow the economic capture theories that previously dominated.4 Notably,
Joseph Schumpeters creative destruction (1942, 83) stressed the importance of
free enterprise in creating breakthrough innovations, while Friedrich von Hayeks
spontaneous order (that which emerges from human interaction, but not human
20


design) was an observation of decentralized markets ability to rationalize
complexity (1967,162). Pitsch (1996) combines these two concepts into one central
insight the need for markets in discovering, rationalizing and evaluating
innovation thus concluding that the benefits of taming corporate power are likely
to pale when compared to the costs to society in delaying and distorting (i.e.,
regulating) innovation.
The Cost of Regulation
Yelm (1998) argues that regulation in general takes too much time, money,
and resources to deliver results. He indicates that the estimated $710 billion annual
price tag to Americans is a convenient way for policymakers to avoid direct taxation
or spending by government. According to Kasten (1998), Americans spend about
$500 billion per year on regulation or $5,400 per household. Clearly both authors
estimates are guesstimates but together they do suggest a serious price is attached
to regulatory processes. In either case, whether this enormous fiscal burden is
worthwhile depends upon whether these regulations make our world a better place
to live. Ill-conceived regulations makes us poorer in that the regulatory tax
lessens our ability to buy better homes, food, cars, clothing and services, such as
telecommunications and information services deemed essential for meaningful
participation in the information-based society of the 21st century.
While the practical consequence of implementation of the 1996 Act may be
that no one will ever again be able eat dinner in peace without the din of a telephone
solicitation, the quantifiable benefits of competition are presumed substantial.
Studies proliferate: According to Hubbard and Lehr (1998, v), the welfare loss from
local monopoly power exceeds $19 billion annually. The Consumer Federation of
21


America (1998) estimates the cost to consumers for each year competition is
delayed in local telephone service to be $10 billion. Popkin (1999) found that
deregulation and consolidation in the telecommunications and other information
transport industries would lead to $92.7 billion in consumer benefits by the year
2005 and at the same time 647,000 new jobs would be created in the information
transport sector providing federal and state regulators relinquish their control.
Bureaucracy
Assuming that it is not generally in the interest of the major beneficiaries of
an arrangement to seek alteration of that arrangement, the maintenance of the
regulatory status quo is the bureaucratic nature of the regulatory agency itself
(Kaufman, 1976; Wilson, 1989). Bureaucratic organizations tend not to shrink or
otherwise dismantle themselves (Kaufman, 1976), and current conservative political
wisdom holds that the regulatory bureaucracy is merely a residual of "liberal
decadence" (Jenkins, 2000). Frequent criticisms include the tendency to expand
their scope and purview and their inability to adapt to the market and technological
changes (see, for example, Kahn in Bell and Singleton, 1998).
Moreover, the contentiousness surrounding change forces the agency into a
more formalistic mode of operation, thus delay and irrationality reach the point
where business decisions are made in high degrees of uncertainty (see for example,
Jenkins, 2000).5 This formalistic mode, characterized by the "multiple advocacy"
model (Porter, 1980, Williams, 1998) has gained momentum since the break-up of
the Bell System in 1984, increasing exponentially since the passage of the 1996 Act.
This is in no small part due to the expansion of the number of stakeholders and
affected parties that have gained standing, thus legal due process, in proceedings
22


before the FCC, state utility commissions, and, by extension, state and federal courts
in the decades leading up to the 1996 Act. Jenkins (2000) argues that to gain the
legal rights afforded by the Act, the development of competition in all
telecommunications and hereto fore unregulated sectors is seriously confounded by
the whims of regulators seeking to remain relevant.
Porter's (1980,241) definition of multiple advocacy, cast in terms of the
chief executive, is "an open, inclusive system designed to expose the President to
competing arguments and viewpoints made by the advocates themselves rather than
... filtered through a staff to the decision maker." Williams (1998) argues that this
definition is equally applicable to other decision-makers such as agency heads and
by extension, state utility commissions. Furthermore, the efficacy of the multiple
advocacy process is a function of (a) sound and orderly management; (b) a decision-
makers) acting as magistrates or honest brokers; (c) the quality of the available data
and analysis; (d) the communication skills of the advocates; and (e) the knowledge
and analytical competence of the participants (p.15). Citing the Reagan presidency
as the sine qua non of the anti-analytic decision-maker, this slippery slope now
appears to have transcended all levels of government. Pure political responsiveness
rather than policy analysis characterized by neutral competence dominates. As a
result, what was once viewed as an independent expert agency has evolved
stereotypically into utility commissions comprised of political hacks with a staff that
is merely trying to survive long enough to move into the private sector or to retire.
A sub-theme hardly unique to telecommunications arises from the
jurisdictional separation of the oversight between federal and state bureaucracies
and with the passage of the 1996 Act, the prospect (real or imagined) of state agency
irrelevance as the national deregulatory plan is implemented. Consequently, the
federal legislation set in motion bureaucratic wars over what the law means and how
best to implement it (see, for example, Dilulio, 1996).
23


Granted, this is only a sketch of the myriad of complaints lodged against the
prevalence of the bureaucracy. It is tempting to surmise, nonetheless, that all roads
lead to the original argument: It is generally not in the best interest of the major
beneficiaries of an arrangement specifically, state utility commissions, to seek
alteration of that arrangement, specifically the loss of regulatory oversight over
basic local exchange service. As will become apparent, the 1996 Act portends, at
least in theory, the last hurrah in the economic regulation of local telephone service,
and by implication, state commission oversight.
Policy Shift
The latter half of the 20th Century saw extraordinary growth in the
unregulated computer industry; by contrast, the heavily regulated
telecommunications industry lagged far behind. Even after the 1984 break-up of the
Bell System, market liberalization in telecommunications services occurred slowly
and unevenly across the states. Fueled by a concern that state-by-state market
liberalization would lead to an inefficient, uncoordinated national (hence, global)
data network, Congress in 1996 passed the landmark Telecommunications Reform
Act, removing all barriers to competition legal, economic, and technological.
The 1966 Act promised to deliver deregulation and free markets to the
telephone, cable television, and broadcast industries. The industry-led compromise
struck by the Act allows for incumbent re-entry into the now competitive long
distance market once robust and irreversible competition has developed in the
incumbent's local market. That is, once de-monopolization of the local telephone
company is irreversible, then and only then is the incumbent allowed to provide in-
region interLATA service.6 This compromise is supposed to ensure that consumers
24


will have a choice of providers, all of which are able to offer bundles of local, long
distance, and information services and to guard against the prospect of an
unregulated monopoly.
Congress established the time frame in which private companies (i.e.,
incumbents and new entrants) were to initially conduct business-to-business
negotiations to complete operating contracts or interconnection agreements ("ICA")
allowing entrants access to the incumbent network facilities. Once the initial
negotiation period ended (135 days), disputed terms and conditions were to be
resolved through an arbitration process. All of this is under the auspices of state
commissions.7 Shortly thereafter, robust competition was expected to materialize.
To that end, the FCC directed state commissions as follows: [o]n those issues
where the need to create a competitive record distinct to a state or to balance unique
local considerations is material.... [w]e ask the states to develop their own rules
that are consistent with general guidance contained herein.8 Optimistically, the
FCC stated, [o]ur expectation is that the bulk of interconnection arrangements will
be concluded through arbitration or agreement, by the beginning of 1997.9
The Transitional Market
How does the transition from monopoly to competition occur? Economic
theory advances the model of the perfectly contestable market. A market is said to
be perfectly contestable if entry and exit are perfectly easy and costless -- that is, if a
competitor can enter without incurring costs to which the incumbents are not
subject" (Baumol and Sidek, 1994, 42-43). Under this theory, rates are set using
both a ceiling (to protect consumers) and a floor (to protect competition). According
to its proponents, transition to competition using this model calls for implementation
25


of the entire solution and requires commissions to render orders and promulgate
rules that are appropriate for the transitional period. That is, the orders and rules
need to have built-in flexibility such that they become superfluous and innocuous
with the passage of time, as a competitive marketplace replaces the monopoly. Tye
(1991,4) contends that [t]o be avoided at all costs, is the adoption of economic
models and regulatory policy that lead inexorably to industry structures and
regulations that are inconsistent with a greater reliance on competition. To do
otherwise, according to the government failure school, is to provide incumbents and
new entrants alike with perverse incentives to make a profit through regulatory rents
rather to compete with each other by creating and selling products that consumers
want.10
Allowing competition is one thing, actually getting it is another. Even when
competitors aggressively seek to enter the local market, it falls to the regulator to
ensure that the incumbent cannot block that attempt with artificial barriers. For
local competition to develop and before allowing entry into the long distance market
by major incumbent monopolies, regulators must ensure that potential new entrants
are not blocked either directly, by technical and / or wholesale pricing tactics of the
incumbent,11 or indirectly by rate structures bom of regulation.
Wholesale pricing for network elements requires regulators to find some
way to untangle the incumbent's internal accounting to allow rivals to lease lines
and equipment at fair prices. And an even trickier problem is pulling apart the
current end user rate system. For competition to develop, prices (wholesale and
retail) must reflect real costs. Current wisdom holds that public policy has
prescribed artificially low basic local telephone rates while those for other services
are set substantially above economic cost. This coupled with the policy of
geographic rate averaging has resulted in a system of implicit subsidies, and with it,
pervasive price discrimination. The remedy for the alleged subsidy problem and its
26


resultant pricing distortions is rate re-balancing. Rate re-balancing is a process by
which the regulator prescribes rules that allow the underlying cost of a service to
19
drive the rate charged to the end user.
The National Deregulatory Framework
The general purpose of the 1996 Act is to promote competition and reduce
regulation in order to secure lower prices and higher quality service for American
Telecommunications consumers and for the rapid deployment of new
technologies.13 Toward that end, the national deregulatory strategy is predicated
on making the public switched telephone network, a vast asset that is privately
owned but paid for by captive ratepayers, available for use by potential new entrants
in return for compensation that is just, reasonable and fair.14 The rapid opening of
the network to competitors is to be accomplished initially by way of network-
sharing arrangements with incumbents; as effective competition takes hold, the
reform of the implicit subsidy system that supported universal service is to occur.
Accordingly, the FCC articulated the "Competition Trilogy that, as the
name implies, comprises three sets of fundamental reforms: local network
unbundling and interconnection, exchange access reform, and universal service
reform.15 The inextricable link between and among these key reforms is forward-
looking economic cost.16 Figure 2.1 below, replete with statutory reference, models
the interrelationship between the three fundamental reform initiatives.
27


Figure 2.1
The Competition Trilogy
The forward-looking economic cost construct assumes that new market
entrants are "efficient." That is, market entry decisions are undertaken without
having to incur the same cost structure as that of the incumbents under the
regulatory compact. The economic cost construct is the methodology prescribed by
the FCC for the costing, hence, pricing of network elements and access services as
well as the cost basis for the service supported by universal service basic local
exchange service. In setting forth this strategy, the FCC concluded that [o]nly
when all parts of the trilogy are complete will the task of adjusting the regulatory
framework to fully competitive markets be finished. Only when our counterparts at
the state level complete implementing and supplementing these rules will the
11
complete blueprint for competition be in place.
Moving beyond the just trust us days where monopolies provided their
own black box cost studies to compliant commissions, reform is to be undertaken
with the aid of competitively neutral economic cost proxy models (a.k.a., forward
looking economic cost studies).18 A proper cost proxy model, reliant on sound
28


engineering design principles, produces a network (again, for purposes of setting
wholesale rates for new entrants) that is least-cost, most efficient, and makes use of
currently available technology. Cost proxy models produce estimates of the
economic cost (i.e., sans historic or embedded cost) to provide network elements
that are reconfigured as plain old telephone service (POTS), exchange access
services, or individual network elements suitable for any combination a potential
entrant may use in the provision of local services. The FCC has consistently
ordered that these cost models must be able to be subjected to public scrutiny in
that, among other things, all inputs, calculations, and results are open and
verifiable.19 Any cost study contemplated; no matter the sponsor, must comply
with the FCCs requirements for forward-looking cost.
As a noted industry economist, Daniel Kelley, testified in the initial market-
opening docket before the Colorado Commission in 1996, the traditional
information asymmetry existing between incumbents and all others prompted the
FCC to require that the incumbent prove to state commissions that the rates for each
element do not exceed forward-looking economic cost of providing that element
(C.F.R. 47 section 51.505(e)). According to Dr. Kelley,
[F]rom the analysts perspective, the results and summary of a cost study
are, in a sense, only the tip of the iceberg: behind each cost study is a
multitude of work papers, and behind the work papers are data sources and
assumptions. All of these need to be reasonably explained and subject to
examination to be able to determine whether a given cost study accurately
reflects the appropriate methodology and accurately estimates costs. ...
sufficient information must be available so that informed analysis and
evaluation is possible.
Moreover,
[Ejxtensive use of non-disclosure requirements tends to protect rather than
expose atypical or idiosyncratic data and individual states do not typically
require LECs to show how their data inputs compare to the data inputs used
by other LECs. ... [i]t is now time for state commissions to pry the lid, once
29


and for all, from the LEC black box and expose the inner working of all
proffered cost models to the light of open debate. 20
The remainder of this chapter summarizes each of the three fundamental
reform initiatives followed by the linkages created by the forward-looking cost
construct. Baseline data are provided for the fourteen states comprising the
evidentiary basis for this dissertation. Justification for the selection of these states is
explained fully in Chapter 5.
Network Unbundling and Local Interconnection. Of the three reforms
required by the Act and the FCC, network Unbundling is not only the most difficult,
but also the logical precursor to the other two. Unbundling requires that prices for
incumbent monopoly network elements be based on economic costs and these must
be determined first to reform access and universal service mechanisms properly.
This is quite logical. Network elements, whether combined for the provision of
basic local exchange service, or disaggregated to provide exchange access services
for interconnection of the local and long distance networks, are functional and
technological equivalents. Existing distinctions between them are the residual of
law and public policy.
The FCC identified twelve basic network elements in the public switched
network that are to be made available to potential competitors on a competitively
neutral and nondiscriminatory basis. These basic or core network elements are
commonly referred to as unbundled network elements ("UNE"(s)).22 State utility
commissions are charged with the responsibility to establish prices for these
elements that are "just and reasonable ... based on the cost (without reference to a
rate-of return or other rate-based proceeding)." To aid in this process, the FCC
established proxy prices for the network elements both as ceilings above which the
state could not go, and as defaults for the states to adopt in the event they elected not
30


to engage in the process of state-specific cost investigations.24 By far, the most
significant cost driver for the provision of local service is the so-called "local loop."
The FCC's average loop-rate ceiling established for the fourteen U S West states is
listed in Table 2.1 below.25
Table 2.1 Comparison ofFCC Loop Cost Proxy for US West States
State $/line/mo. State $/line/mo.
AZ $12.85 NE $18.05
CO $14.97 NM $18.66
ID $20.16 OR $15.44
IA $15.49 SD $25.33
MN $14.81 UT $15.12
MT $25.18 WA $13.37
ND $25.11 WY $25.11
Source: 47 C.F.R. § 51.513 (c)(1)
Figure 2.2 provides a logical representation of the basic network elements
wherein rate elements are grouped together as either "facilities" or "systems." For
example, the loop facility, labeled number 1 in Figure 2.2, is made up of the
network interface device or NID, the loop, and the line side switch port. Facility 2
includes the local switch and all of its functionality (e.g., features such as caller ID).
A "system" designation, such as facility number 5, includes operational support
systems that are associated with ordering, provisioning and / or maintaining network
elements or services. At the edge of facility number 3 (transport) there is a
"network cloud." The cloud is a generic representation of another network
wireline (local or long distance) or wireless. This is the point at which these
networks are connected or point of interconnection.
Rates for the network elements alone reveal little about whether they
promote competitive entry. To begin to make that determination, network elements
must be combined into a useful service offering and compared to a similar offering
made by the incumbent carrier. The appropriate comparison is for basic local
31


Figure 2.2 Basic Network Elements
OJ
K>
Loop Facility
; Local Serving Wire Genter
Transport Facility
: Signaling Facility
Operations Support Systems
; Ancillary:Service Systems


telephone service because the combination of all of the UNEs, termed UNE
platform ("UNE-P"), is the equivalent of plain old telephone service or POTS. A
local telephone call provisioned by leasing the facilities of an incumbent to provide
POTS includes the rate elements comprising the loop (1), switch (2), and transport
(3) depicted in Figure 2.2.27Technologically, aggregation of the unbundled network
elements is equivalent to basic local service residential or business. It follows
that a new entrant can compete with the incumbent for local customers if the rate for
the sum of the network elements is no greater than the price the incumbent's
customer pays for that same service or
UNE-P < P
where
UNE-P = sum of unbundled network elements.
P = Price of basic local exchange service.
A simple hypothetical example is offered subject to the following
assumptions:
(a) The sum of the wholesale prices for the UNEs are averaged or have the effect of
being averaged over the entire geographic service area of the incumbent local
exchange carrier("ILEC"). The wholesale price of the UNEs ordered by the state
commission is $25.00 per unit.
(b) The regulated retail prices are averaged or have the effect of being averaged
over the entire geographic area of the incumbent. Those prices are $ 15.00 / month
/ line for residential service and $35.00/ month / line for basic business service.
In this hypothetical example, the wholesale price of the UNE-P ($25.00) if
provisioned for residential service would exceed the current rate paid by residential
consumers ($15.00) by $10 / line / month or a revenue loss of $120.00 per year.
The wholesale price for the UNE-P ($25.00) is less than the regulated retail rate
($35.00) paid by business customers by $10.00 / line / month or a revenue gain of
33


$120.00 per year. One need not be encumbered by brilliance to conclude that there
is no point in trying to compete with the incumbent for residential subscribers at a
loss of $10.00 per line per month. Business customers, all other things being equal,
provide such potential. This hypothetical is expanded later in this chapter and
provides an important methodological preview of the findings contained in Chapter
6.
Invariably, the next two reforms are very confusing. It is helpful to begin by
crafting an old-world / new-world view of how carriers recover the cost of
providing service(s) to consumers. Borrowing from O'Grady (2001,10-12) one can
summarize the monopoly management task faced by the regulator. In the old-
world, the single firm monopoly (within a territory) operated as an agent of
government or in compact with government regulators. Accordingly,
The industry was managed in a fashion where, figuratively, the company
simply put all of its bills in a shoebox and the state then allowed the
companies to recoup the sum of the bills from end users. Thus the principle
guiding the industry was one of setting total revenues to equal total costs. ...
With respect to pricing various service elements (that is, rate making),
regulators and monopolists had the widest possible discretion.
Among other things, the result of this compact was little concern for
efficient resource use as opposed to other policy goals. By contrast, the new world
model seeks efficiency through the interaction of numerous competitors as the best
policy for consumer protection. As a result, competition can only be encouraged by
allowing the rates for each and every element and service to reflect the cost to
society to produce that rate and service. As such, regulators must relinquish some
control to allow the market to work because
[e]ach competitor, by definition, shares the industry with other competitors
and offers some subset of services to some subset of customers. Thus, return
on investment for every subset of services and customers must be reasonable
on order to attract competitors. It is no longer sufficient to simply allow the
34


single monopolist the opportunity to make a reasonable return on the total
investment.
The critical difference in cost determination between the old and new (in
terms of the measure of cost appropriate for the development of competition) is that
between total cost recovery in the monopoly environment and marginal cost
recovery in the multiple carrier environment.
In the transition to the new-world order, however, efficient prices alone are
not sufficient to encourage competition in all areas for all services. To some extent,
and now as a matter of federal law (section 254 of the Act), competition must be
"purchased" through subsidies to telecommunications providers, specifically (a) low
income consumers, (b) high cost consumers, and (c) access to advanced services for
schools, libraries and rural health care providers (47 U.S.C. 254(b)). There are, of
course, better and worse ways to subsidize providers. Nonetheless, to the extent that
total market efficiency can be encouraged, the total subsidy requirement can be
reduced.
Reforming the Access Charge Regime. What is important about intrastate
access charges is that they allegedly comprise the vast amount of cross subsidization
in support of universal service (/. e., the rate for basic local service) in the form of
general subsidies. At the state level, much of it is collected as part of the access
charges long distance carriers pay to local telephone companies to provide local
connections to their interstate and intrastate toll customers. This means that access
charges are prescriptively priced at many multiples of cost and are passed on to the
consuming public in the fprm of higher long distance charges. Access charge
reform portends a reduction in the number of regulatory options available to policy
makers for this indirect or hidden form of taxation. The heart of the access charge
35


debate is whether reform should be driven by prescription, market forces, or a
combination of the two.
Access charges are a matter of both the federal and state ratemaking.
Although the logic of reform contemplated by the 1996 Act is identical between the
jurisdictions, the pace of reform varies significantly.28 In the interstate jurisdiction
(not the concern of this dissertation) the incumbent company is regulated at the
holding company level and, therefore, reform of the interstate access charge regime
applies evenly to the entirety of the incumbent's operating territory and in the same
time frame. In the state jurisdiction, each state has the discretion to reform access
charges in accordance with its own local conditions. Given the evolution of the
industry, however, it is unlikely that market forces alone can be relied upon for
reform because
The price of access is not directly visible to the consumer, it is a wholesale
input hence the indirect tax effect.
Terminating access is generally set higher than originating access even
though they are technological equivalents.
Access tariffs are a catalogue of rates and services available to all
interexchange carriers (IXCs), so no IXC can strike a better deal than can
another IXC.
The IXC must offer the same rates in all geographic regions of the state (47
U.S.C. 254(g).
Access charges comprise a significant portion of current incumbent
revenue. The incumbent has little incentive to reduce access rates in the
absence of an explicit universal service fund and even then, the incumbent is
loath to risk exposing any excess or the appearance thereof to objective
analysis.
36


As O'Grady (2001, 31) argues "these factors appear to comprise a Gordian
knot which, arguably, only the regulatory sword may sever." To begin to appreciate
the magnitude of switched access charges, Table 2.2 compares the unit cost for
intrastate access rates in the fourteen U S West states. For this comparison,
switched access rates expressed as a unit cost are multiplied by switching minutes to
produce an estimate of these charges. At the signing of the 1996 Act, the amount
paid to the major incumbents carriers (RBOCs and GTE) was approximately $20
billion annually in the interstate jurisdiction while the economic cost of access was
approximately $5 billion annually. Preliminarily, in the intrastate jurisdiction, the
amount paid to U S West in the fourteen states measured on a per minute of use
basis was approximately $830 million annually while the economic cost of switched
access was approximately $52 million annually.31
37


Table 2.2
Comparison of Intrastate Access Rates
(1996)
State Unit Cost National Rank Volume (000's min) Total $ (millions)
(a) (b) (a)*(b)
AZ $0.09 17 1,141,385 $98.16
CO $0.12 6 1,192,562 $143.11
IA $0.08 22 1,159,253 $92.74
ID* $0.14 2 268,739 $25.60
$0.08 18
MN $0.08 21 1,866,459 $149.31
MT $0.09 16 354,831 $31.93
NE $0.12 5 484,823 $58.17
ND $0.11 7 283,952 $31.23
NM $0.13 3 220,275 $28.64
OR $0.06 29 1,063,272 $60.60
SD $0.06 30 210,462 $12.63
UT $0.07 25 287,230 $20.68
WA $0.09 11 1,801,710 $162.15
WY $0.10 8 76,304 $7.63
Total: 10,411,257 $829.84
Two lowest states:
IL $0.03 49
CA $0.02 50
Source: Access unit cost: from US West Exchange Access Services
Tariffs; unit cost comprised of (originating CCL + terminating CCL +
(traffic sensitive rate x 2). Intrastate call volumes from ARMIS 43-
OS Operating Data Report, Jan. 1996-Dec. 1996, column (ei).
* At the passage of the 1996 Act, Idaho was bifurcated into two distinct
operating entities, each with a different regulatory regime even though
regulated by the same state PUC.
At the passage of the 1996 Act, U S West states represented six of the top
ten highest switched access rates nationally. Of the fourteen U S West states, South
Dakota had the lowest rates and was ranked was ranked 30th lowest in the nation.
By comparison, California and Illinois had the lowest per minute rates at 1.7 and 2.7
cents per minute respectively.
38


Successful implementation of the competition trilogy, technological
rationality and economic orthodoxy demands that the economic cost of switched
access mirror the economic cost of its UNE functional equivalents i. e., switching
and transport -- no more no less (Kahn, 1970 &1984; Kaserman & Mayo, 1994;
Hausman & Tardiff, 1998; Mayo, 2000). The initial condition is far more complex.
In reality, not only are these rates set in excess of economic cost, there are
additional switched access rate elements and / or services as well. In the aggregate,
the cost of switched access in the U S West states exceeds economic cost by $778
million annually or approximately 1600%. Thus, the potential harm to the
development of competition embedded in access charges is revealed. If the
incumbent local monopoly is allowed to retain a revenue windfall of this magnitude
(the product of the inefficiencies inherent in regulation, hidden taxes, and, lax
politicians), it constitutes a significant war chest with which to subsidize the rates
for any other service exposed to a competitive threat.
To the extent access revenue today subsidizes the rates that consumers pay
for basic local exchange service, this subsidy and its actual need must first be
accurately quantified and recovered in a competitively neutral manner (more under
universal service). To the extent access charges have been set in excess of such
explicit need, the excess should be removed from the rate base. That is, access
reform requires the elimination of unnecessary rate elements and any revenue
windfall associated with switching and transport.
Universal Service Reform: Making Competition and Subsidy Compatible.
Section 254(b) of the Act mandates that universal service be preserved and
advanced based on certain principles. These principles include, but are not limited
to, rates that are just, reasonable, and affordable; nationwide access to advanced
39


services; and rates and services that are reasonably comparable between rural
and urban communities. Section 254 of the Act poses a dilemma for federal and
state regulators. They must deregulate local service, a goal in which subsidies
currently buried in rates for other services are discriminatory against certain classes
of customers and economically unsustainable while also expanding a social policy
that presumes the necessity for subsidy mechanisms.
Kasserman and Mayo (1997, 7) provide a definition of universal service
most directly founded on economic consideration as the promotion of increased
subscribership to the telecommunications network in the most economically
efficient manner. This definition stems from what has been termed the network
externality. The externality argument is described by John Wenders (1987):
Subscriber externalities result from the fact that the value of the network to
any subscriber depends in part on the number of other subscribers available
- when a new subscriber joins the network, he makes the whole system
slightly more valuable for each of the other subscribers.
The existence of the network externality, however, produces a public policy
that promotes subscribership beyond the level that would occur under pure market
pricing of telephone service. Thus, the subsidy system today is implicit in the rates
for other services that are more price elastic than is basic local telephone service;32
not targeted to those in need, in that no means test applied to the high cost portion of
the subsidy system and is paid directly to carriers; discriminatory in that the cost is
bom mostly by long distance customers; administered by an organization of
incumbent monopoly providers, one that is not competitively neutral. (Eriksson, et
el., 1998)
The prevailing political definition of universal service includes the notions
that local rates should be kept affordable and that there is a specific set of
telecommunications services to which all Americans have should have access.
The convoluted regime of cross subsidies that is increasingly suspected to have
40


benefited stockholders at the expense of ratepayers must give way to a subsidy
system that is designed such that it is compatible with competition.33 According to
Kasserman and Mayo (1997) and Eriksson, Kasserman & Mayo (1998) those design
principles include (a) making the subsidy explicit; (b) funding the subsidy broadly;
(c) targeting the subsidy narrowly; (d) making the subsidy portable with the
customer; and (e) administration of the size, collection, and distribution of the
subsidy by a neutral third party.
Under the 1996 Act, the goals of "universal service" include (a) maintaining
current levels of subscribership to the network at affordable rates, (b) promoting
increased subscribership to the network for low income consumers, and (c)
providing access to advanced telecommunications and information services for
schools, libraries, and rural health care facilities. Achievement of these goals is to
be accomplished by four distinct subsidy mechanisms: the High Cost Fund targeted
to high-cost carriers; the LifeLine and LinkUp Programs targeted to low-income
subscribers; and the E-Rate Program targeted to libraries and rural health care
facilities. It is the high-cost subsidy mechanism that is the focus of this dissertation
and that is commonly referred to interchangeably with the term universal service.
Since 1984, the federal High Cost Fund has been exclusively, the purview of the
federal government.34 Under the 1996 Act, however, section 254(f) explicitly
allows for the creation of state-specific subsidy mechanisms for "additional
definitions and standards" for the "preservation and advancement universal service,"
to the extent that they are "not inconsistent with the federal mechanisms" and that
"do not rely on or burden the federal mechanisms." The FCC has made it clear that
there is no automatic or compelling need for any state to establish such a subsidy
mechanism.35
At the release of the FCC's First Report and Order addressing universal
service reform in May, 1997, only one U S West state, Wyoming, received any
41


federal high cost support. State funds, to the extent they existed likewise provided
no high cost support to U S West. By comparison, the independent telephone
companies operating in the U S West region were recipients of both federal and
state funds (see also FN 34). The amount of federal and state high cost support for
the fourteen US WEST states for 1996 is reported in Table 2.3 below.
Table 2.3 State and Federal High Cost Support
(1996)
State Number of Companies Federal Support State Support ICOs U S West Support Fed/ State
AZ 16 15,625,845 $765,000 None
CO 28 $4,047,767 $560,000 None
LA 154 3,560,167 None None
ID 21 17,432,063 $1,562,472 None
MN 88 7,989,740 None None
MT 18 12,068,325 None None
ND 24 3,813,765 None None
NE 41 4,846,571 None None
NM 15 16,238,092 None None
OR 33 9,837,250 $6,956,950 None
SD 31 2,328,390 None None
UT 13 2,732,858 $17,000,000 None
WA 23 15,853,445 $9,100,000 None
WY 10 $7,370,745 TBD $1.3m (federal)
Total 515 $123,738,000 $35,944,422
Source: Federal subsidy and number of companies from NECA Study Area Report
USF3013, 1998 report for 1997. State funds are derived mainly from estimates
from different sources. NM is estimated by staff and is defunct in that no carrier
draws unless it subjects an earnings investigation; Co fund is estimated based on
end user billing line item amount; AZ and UT are estimated based on AT&T's %
contribution extended to whole IXC industry; WY was newly created and not yet
calculated in 1996. The WA, OR and ID funds are reported by their
administrators.
The system of general universal service subsidies, commonly referred to as
implicit subsidies, developed when local telephone service was a monopoly. The
subsidy system, however, is no longer sustainable following the new national policy
42


of local competition. The dilemma facing regulators is one of policy design. How
does the regulator design a subsidy system such that it causes the least amount of
distortion to the prices for all telecommunications services?
Linking the Reforms
With the cost of the network elements serving as the common denominator,
the following describes the cost relationships between and among the three sets of
reform and as set forth graphically in Figure 2.1. First, we review that between
UNEs and equivalent access services, second that between the sum of the UNEs and
the cost of basic service (i.e., universal service) and third that between the cost of
access services and the cost of universal service.
UNEs and Access Reform.
Preliminarily, in the world of a "network of networks," the exchange of
traffic between carriers should be based on the notion that a "minute is a minute,"36
thus so-called intercarrier compensation for the exchange of any class of traffic
(local or long distance) should be identical or very close to it. Figure 2.2 identifies
both the point of traffic exchange between networks as well as the network elements
used for that function. The point of exchange occurs within the area designated as
transport facility (3) and the network cloud. The rate elements employed include
local switching, common transport, and tandem switching.
Generally, a carrier incurs cost and is entitled to (intercarrier) compensation
for that cost when traffic either originates or terminates on its network. In the
43


context of competing local carriers, this compensation is for what is termed the
transport and termination of local traffic. The FCC, recognizing the incentive for
incumbents to use their bargaining strength to extract excessively high rates for new
entrants, concluded that pricing for local traffic exchange should be symmetrically
applied to terminating local traffic and based on the rates established for large
incumbent carriers (here, U S West). In setting rates for local traffic exchange,
termed "reciprocal compensation," the state commissions have three basic policy
options. They can (a) establish a positive, reciprocal rate to be paid by each carrier
to the other by combining rates for the relevant basic network elements (i. e., local
switching, common transport and tandem switching); (b) adopt the FCC's proxy
prices; or (c) they can adopt a default policy option termed "bill and keep."38 Bill
and keep (B&K) assumes that traffic between two carriers is roughly in balance,
rates between carriers do not vary, and, therefore, the transaction costs associated
with carriers paying these charges to each other outweigh the compensation
received. Carriers keep track of these charges but do not pay each other for this
39
transaction.
As with the earlier comparison between UNEs and basic local service, rates
alone reveal little about whether a commission's pricing decisions tends to promote
competition. A comparison of the difference between the rates for reciprocal
compensation and those for a technological equivalent sheds some light on this
question. That technological equivalent is found in the rates for exchange access (or
switched access) services paid by IXCs to incumbents for the exchange of toll
traffic within a given state. A comparison between these is possible when each is
expressed as a blended per minute of use rate. This comparison, its analysis and
implications are contained in Chapter 6.
44


UNEs and Universal Service
A partial explanation of this linkage occurred earlier. Recall the discussion
of the technological equivalency between the sum of the UNEs and basic local
service. Basic local service in the jargon of universal service is also, by definition,
the "supported" or subsidized service unless and until that definition is expanded
consistent with the criteria set forth in section 254(c) of the Act.
Returning to the hypothetical, the current retail price of basic residential
service is averaged at $15.00 and the wholesale cost of the UNEs is averaged at
$25.00. The non-discrimination principle embodied in the Act and the FCC's
Orders is that by definition, the cost to the new entrant for the UNE-P is the same
cost the incumbent incurs to provide that service to itself. That is, the underlying
cost of basic service, whether provisioned by the new entrant using UNE-P or the
incumbent using its own network is $25.00.
Logically, the way the determination is made about the need to "purchase"
(i.e., subsidize) competition (here only residential is considered) is based on the
difference between the cost of basic service reduced by the revenue received for that
service multiplied by all of the lines in the entire geographic area. In this case, that
difference is ($10.00) line per month. Assuming an area of 100 lines, the total
subsidy needed is $1000 per month to the carrier that wins the customer. To
summarize:
No. Lines_____Total Cost___________Total Revenue_______________Subsidy
100 (100*$25) (100*$15) $2500-$1500
______________$2500________________$1500_______________________($1000)
45


A more precise way to make a determination of whether and to what extent a
subsidy is needed is to differentiate between high cost and low cost areas within a
given incumbent carrier serving area. This differentiation is known as "geographic
deaveraging." Under this scenario the cost of the UNEs more closely reflects the
underlying cost to provide service by disggregating the incumbent's service area into
"density zones." The FCC mandated that that the states dis-aggregate the loop to a
minimum level of three zones based on economic cost.40 Generally, the greater the
distance from the incumbent central office (i.e., switch) the longer the loop and the
lower the number of customers, the lower the density, hence the higher the cost to
serve. The hypothetical is revised below to underscore the efficiencies to be gained
from wholesale cost deaveraging. The average UNE cost of $25.00 is disaggregated
into three zones. Zone 1 is the highest density, least cost zone and zone 3, the
lowest density highest cost something akin to the difference in Colorado say
between Denver, Arvada, and Antonito. Assuming here there is no commission
appetite for rate re-balancing, the retail price of the service remains at $15.00 / line /
month throughout the entire service areas regardless of the underlying cost to serve.
Zone Cost No. Total Total Total
Lines Cost(TC) Revenue(TR) Subsidy
(a) (b) (a*b) (b*$15) (TC-TR)
1 $9.00 60 $540 $900 ($360)
2 $15.00 35 $525 $525 $0.00
3 $100.00 5 $500 . $150. $350;
Total: 100 1565 1575 GO)
Clearly, the efficiencies gained from deaveraging under this scenario allow
competition to be "purchased" in Zone 3 (shaded line) at a savings to society of
$650 / month. Instead of subsidizing all 100 lines at $10 / month, only 5 lines are
subsidized at $350 / month. Under this scenario, only Zone 3 (shaded) requires a
46


positive subsidy to maintain the retail price of $ 15.00. Zone 2 shows revenue
exactly covers cost, and, for Zone 1, revenue exceeds cost by $360.
For now, the principle of cost disaggregation is sufficient to understand the
logic of the trilogy. When it comes to actually sizing the subsidy, however, cost
must be compared to a benchmark that approximates all of the revenue the
incumbent expects to receive (a) for a basket of local services typical of the average
customer and (b) for all of the services that make use of the same network elements
(UNEs)) comprising the cost of the supported service(s). This calculus guards
against providing a subsidy for a customer that is already profitable for a carrier to
serve (more about this in Chapter 6).
Access Reform and Universal Service Reform
The FCC identified three key sources of potential subsidy for basic local
rates: geographic averaging; the price differential between residential and business
rates; and intrastate access charges.41 Of these, the most contentious is intrastate
access charges, a wholesale input of the rates charged to consumers for long
distance service. There is a growing body of work that concludes that more harm is
done to consumers by this type of price discrimination than would otherwise occur
if local rates were increased, assuming this type of rate rebalancing was necessary in
the first place (see, for example, Crandall & Waverman, 2000; Kaserman & Mayo,
1996; Kahn & Tardiff, 1997; Hausman, Tardiff & Belinfante 1993). Significantly,
prior to the 1996 Act, no commission in the fourteen-state U S West territory had
ever made a determination that the local rates for basic service for the U S West
serving area are set below the cost to U S West of provisioning that service. The
47


rates for basic local exchange service for the fourteen states is contained in Table
2.4 below.
Table 2.4 14 State Comparison of US West Basic Local Exchange Rates
(1996 by major metropolitan area)
State Residential Business
AZ (Phoenix) $13.18 $32.78
CO (Denver) $14.93 $37.37
ID (Boise) $12.00 $31.10
IA (DesMoines) $13.05 $32.15
MN (Minneapolis) $14.58 $43.75
MT (Billings) $13.84 $38.69
ND (Fargo) $14.15 $43.11
NE (Omaha) $15.40 $38.55
NM (Albuquerque) $16.01 $51.12
OR (Portland) $15.65 $35.17
SD (Sioux Falls) $17.65 $37.50
UT (Salt Lake) $11.82 $27.15
WA (Seattle)* $10.50 ($12.50) $27.20 ($26.89)
WY (Cheyenne)** $16.25 ($18.00) $30.56 ($23.10)
Source: U S West Network and Exchange Tariff for each state,
the federal end user common line rate ($3.50 per line per month
residential and $6.00 per line per month business) is not
included.
* The rates were temporary based on the results of the 1995 rate
case and were increased by $2.00 per line pre month for
residential with a slight decrease in business almost immediately.
** Rates in effect prior to implementation of the U S West rate
case that concluded year end, 1995. Rates increased to $18.00 for
residential and down to $23.10 for business almost immediately.
In 1996, with the passage of the Act, seven of the U S West states ranked
among the top ten highest access rate states in the nation (see Table 2.3). Intuitively,
these fourteen state commissions should be able to undertake reasonable measures
of access reform in the U S West areas without the intense political pressure
stemming from the prospect of significant increases in basic local rates. In the rural
areas of the states, one would expect the same but for a different reason. There,
48


ridiculously low basic rates ([e.g., $4.50 in one rural serving area in Nebraska) and
relatively higher long distance calling patterns it would seem should lead to access
reform undertaken with a minimum of political outcry.42
Summary
The national deregulatory strategy relies on state regulators to (a) formulate
policies for "arbitration" of interconnection between carriers with the goal of
facilitating competition by allowing entrants to "share" the incumbents network; (b)
reform the carrier access charge regime to remove excess contribution or monopoly
rent; and (c) restructure universal service to make it compatible with competition.
The rates charged to entrants by incumbents for access to their networks and
services are intended to bring entry incentives more closely in line with economic
efficiency. These are important steps in the liberalization of the local services
market such that competition is allowed to develop, thus eventually supplanting
regulation with competition for the protection of consumer welfare.
Even in the emergent world of high-speed data access and global
communications, competition in local services is inextricably linked to the ability of
average consumers and small businesses to participate in this technological
phenomena. It is reasonable to assume, therefore, that sooner rater than later, all
state commissions will have to adopt the view that long distance service is at least
equal in social value to basic local service and in doing so, abandon the
discriminatory pricing policies that have dominated in local telecommunications.
The purpose of the Act, to promote competition and reduce regulation, and
section 254 of the Act, the mandate to preserve and advance universal service, sets
up the classic public policy debate inherent in the tension between social efficiency
49


and equity. In Chapter 3 we turn our attention to that debate throughout 125 years
of U. S. telecommunications policy.
50


NOTES
1 While the conceptual framework for this dissertation emerges from Chapter 4, "Dialogue with the
Literature," the final section of this Chapter comprises the analytical framework for data
manipulation set forth in Chapter 5, "Methods of Inquiry."
2 Discretionary services include call forwarding, call waiting, and three-way-calling.
3 47 U.S.C. 1. Purpose of the Act; Creation of the Federal Communications Commission. 1934.
4 See for example Stigler, 1971; Peltzman, 1976; Posner, 1971. Capture and interest group theory is
explored in greater detail in Chapter 4 of this dissertation.
5 Witness the spectacular rise and fall of the so-called DataLECs in the ten month period between
March and December, 2000, among them JATO, Rhythms, COVAD, and Northpoint.
6 A Local Access and Transport Area (LATA) is a geographical designation that originated with the
break-up of the Bell System in 1984. InterLATA toll service was confined to the long distance
carriers such as AT&T, MCI and SPRINT and is regulated by the FCC. IntraLATA toll services was
confined to the incumbent local exchange carriers and is regulated by state commissions. The ability
for the incumbent local exchange carriers to offer in region interLATA toll service prematurely
would, in effect, re-monopolize the provision of all telecommunications services within that
operating region.
7 47 U.S.C. § 252(a)-(b).
8 Before the Federal Communications Commission, In the Matter of the Implementation of the Local
Competition Provisions in the Telecommunications Act of 1996. CC Docket NO. 96-98.
Interconnection between Local Exchange Carriers and Commercial Mobile Radio Providers. CC
Docket No. 95-185. rel., August 8, 1996. ("Local Competition Order") 22.
9 Local Competition Order, §22.
10 The current electric power crisis in California is a real live example of the results of a policy that
combines the (worst/best??) traits of government and market failure simultaneously.
11 Technical barriers to entry, the purview of network engineers, are beyond the scope of this
dissertation but include, for example, the ability or lack thereof to (a) transfer or "port" existing
customer assigned telephone numbers to competing service providers without disruption of service;
(b) locate competing carrier transmission equipment in the central office of the incumbent, termed
collocation; and (c) develop operational support systems (OSS) capable of handling mass market
wholesale transactions between carriers such that the functions of ordering, provisioning and
maintaining service between carrier is seamless to the consumer.
51


12 Prior to the break-up of the Bell system in 1984, the pricing of regulated telecommunications
services deviated from economic orthodoxy in terms of both access to the network and usage of the
system in that costs were not recovered in the manner that they occurred. Meuller (1993, 11-30)
provides a comprehensible explanation of this quagmire.
13 Telecommunications Act of 1996, Pub.L.No.104-104, 110 Stat. 56, 47 U.S.C. § 151, etseq.
14 (47 U.S.C. §251(b)(2)(D)).
15 Local Competition Order, §6-9.
16 As defined by the FCC, forward looking economic cost is the sum of (1) the total element long-
run incremental cost of the element; and (2) a reasonable allocation of forward-looking common
costs (C.F.R.47 §51.505). The total element long run incremental cost (TELRIC) of an [network]
element is the forward-looking cost over the long run of the total quantity of facilities and functions
that are directly attributable to, or reasonably identifiable as incremental to, such element, calculated
taking as a given the incumbent LECs provision of other elements (C.F.R. 47 §51.505(b)). Forward-
looking common costs are economic costs efficiently incurred in providing a group of elements or
services (which may include all elements or services provided by the incumbent LEC) that cannot be
attributed directly to individual elements or services (C.F.R. 47 § 51.505(c)).
17 Local Competition Order, § 9.
18 The use of forward looking cost models or cost studies is itself a hotly contested proposition that
is still winding it way through the process of judicial review. I take no position about whether this is
the right or wrong methodological approach. It is currently the law of the land and will, therefore, be
presumed appropriate for purposes of this dissertation.
19 In The Matter of The Federal-State Joint Board on Universal Service, CC Docket No. 96-45.
FCC Order 97-157, rel. May 8, 1997, § 250(8). (USO).
20 Direct testimony of Daniel Kelley on behalf of MCI Telecommunications Corporation. Filed
September 6, 1996. Docket No. 96A-366T. pp. 15-17.
21 FCC 96-325 First Report and Order, CC Docket No. 96-98. rel., August 8, 1996. f 366-529.
22 This acronym is used extensively in the Chapters devoted to Methods and Findings and is thus
much easier to read in the manner in which it is commonly pronounced i.e., "You -Knees."
23 47 U.S.C. § 25 l(d)(l(a).
24 47 C.F.R. § 51.513(c)(1). Table B.l in Appendix B of this dissertation provides the FCC's proxy
costs for all fifty states, Washington D.C. and Puerto Rico.
25 This dissertation contains numerous tables. For consideration of space and clarity, I have
substituted the postal abbreviation for the fourteen states as follows: Arizona (AZ), Colorado (CO),
Idaho (ID), Iowa (IA), Minnesota (MN), Montana (MT), Nebraska (NE), New Mexico (NM), North
Dakota (ND), Oregon (OR), South Dakota (SD), Utah (UT), Washington (WA and Wyoming (WY)..
52


26
This is the small plastic box that is attached to the outside of a residence and, although simple in
appearance, carries a lot of regulatory baggage. First, it is the point at which the deregulated "inside
wire" in the home is connected to the network. Inside wire, in turn, is connected to the subscribers
telephone also the subscribers responsibility. Second, it is the demarcation point between that
which is regulated and that which is not. Thus the telephone company, not the subscriber, owns the
NID. This should explain why, when it falls off the wall of the house during a storm, the subscriber
can not simply go to a hardware store and replace it. Competing carriers must have access to this
NID to provide service.
27 To avoid confusion and unnecessary complexity, per line estimates of the costs for system
elements, OSS, signaling and ancillary services, has not been included. The reasons vary according
to the system but generally the rate design for prices to CLECs are not established on a per line per
month basis, they are not consistent across the states and the CLEC may or may not have need for
some of these system elements from the incumbent. As a result, the elements that have been
included are those that any CLEC would, at a minimum, expect to pay for the UNE platform.
28 Section 254(b)(5) of the Act states that federal and state support mechanisms (i.e., subsidies)
"should be specific, predictable, and sufficient" implying that all subsidy mechanisms be made
explicit.
29 I retain the distinction between rural and non-rural carriers as defined by the 1996 Act. In the
interstate jurisdiction, access reform thus far only applies to the non-rural carriers or here U S West.
State commissions have the ability to reform access charges upon their own motion or through state
legislative mandates.
30 Estimates vary, but for US West generally, it is 30% and for the rural carriers, 60%.
31 The calculation for intrastate access is not indicative of total intrastate switched access revenue.
This is a conservative estimate in that does not include revenue for non-recurring charges and fixed
charges, most notable associated with the transport switched access revenues.
32 Most notably, long distance services.
33 Evidence, presented in Chapter 6, is beyond the anecdotal. See, for example, Federal
Communications Commission, Common Carrier Bureau Accounting Safeguards Division, "Audit of
the Continuing Propoerty Records of U S West Telehpne Operating Companies as of June 30, 1997.
rel., December 22, 1998. Among other things this audit finds that U S West had overstated its
investment related to hard-wired equipment by $378.6 million," 17,300 lines item representing
$281.6 million in Undetailed Investment and 30,300 line-items representing $121.8 million in
Unallocated Other Costs. See also, Audit Report of the Inspector General for the USDA. Rural
Utilities Service Telephone Loan Program Policies and Procedures. Washington, D.C. Audit Report
No. 09016-1-T, rel., February, 2000.
34 Owing to the telephone accounting system known as the jurisdictional separation of the cost of
the network, certain states have established pre-act high cost subsidy mechanisms generally accruing
to the states rural carriers. These pre-act state subsidies are more fully illuminated in Chapter 6.
53


35 In the Matter of the Federal State Joint Board on Universal Service, Seventh Report and Order
and Ninth Report & Order, CC Docket No. 96-45.
36 Classifications of telecommunications traffic such as local, long distance, and local toll are legal
not technological distinctions. Local traffic is governed by sections 251(b)(5) and 252(d)(2) of the
Act, while access services are governed by sections 201 and 202 of the Act. Likewise, the pricing
distinction between residential and business local service is a regulatory distinction lacking a
technological difference.
37 Local Competition Order, 85, 101, 103-105
38 Local Competition Order, f 71, 127-131.
39 Generally the B&K policy, where adopted, is bounded by a time and traffic imbalance caveat.
For example, in Washington, B&K adopted in the arbitration is for a two year period unless traffic
between two carriers is out of balance by 5%. Out of balance by 5% triggers payment by each carrier
to the other for terminating traffic at rates established in the ICA.
40 47C.F.R. § 51.507(f).
41 USO f 271.
42 The alleged absurdity of relatively low rates to be found in rural America are often compared with
the average $40 month the same consumers are willing to pay for cable TV service (see, for example,
Gasman, 1998). Additionally, the notion that rich rural consumers (Jane Fonda, ever on the cutting
edge of social issues, and Ted Turner at their ranch in Montana were the poster children for this
analogy) were entitled to pay less, while their less fortunate urban brethren pay more to support
them. This example engendered heated debate at least in front of less prosperous commissioners.
See, for example, transcript of Wyoming hearing, protesting the implementation of the state universal
service fund. August, 1997.
54


CHAPTER 3
THE TELECOMMUNICATIONS REVOLUTION
[IJmproved communications ... [in] the last 50 years have brought about a
revolution in this field.
History does not always repeat itself but as Mark Twain may have said, it
rhymes (Anderson, 1999). The quote at the top of this page is not the insight of a
professional futurist. Rather, it is taken from Das Kapital, Karl Marx's unfinished
magnum opus published on or about September 2, 1867.1 Marx, commenting on the
worldwide revolution in communications, observed that the entire globe is being
girdled by telegraph wires. The word revolution has frequently been used and
abused when describing more than a century of relentless and occasionally profound
technological innovation in communications. The point is, of course, that
revolution is a word with many faces and one that conjures up visions of quick or
abrupt and even brutal change or, as it is used here, profound and fundamental
transformation. The emphasis here is on depth rather than speed, and it should
surprise no one that the extraordinary technological advances of the current
revolution in communications did not occur overnight. As economic historian
Landes (1998,187) observes, [f]ew inventions spring mature into the world. On
the contrary: it takes a lot of small and large improvements to turn an idea into a
technique.
Inventions themselves neither constitute nor cause revolutions. Colin Cherry
(in Pool, 1977, 112) argues:
55


Their powers for change lies in the hands of those who have the imagination
and insight to see that old constraints have been removed, that their political
will, or their sheer greed, are no longer frustrated, and that they can act in
new ways. New social behavior patterns and new social institutions are
created which in turn become the commonplace experience of future
generations.
Moreover, Such realization does not come easily, quickly or even naturally, for
the new invention can first be seen by society only in terms of the liberties of action
it currently possesses. Take electronic voice communication. Operating under the
theory that transmission of an electric current varying in intensity precisely as the
air varies in pressure was possible, experimenters Alexander Graham Bell and
Thomas Watson set about to improve upon Samuel B. Morses invention, the
telegraph. Telegraphy was limited to the transmission of one sound at a time over
each wire. Bell and Watsons device, the harmonic telegraph, picked up the
accidental twang of a plucked reed. The speaking telephone was bom at that
moment when the realization was made that a mechanism that could transmit all the
complex vibrations of one sound could do so for any sound, including the human
voice. Technical capability, however, does not mean immediate and wide spread
use. Even though we possess the technical capability to send humans to the moon
today, we have yet to establish regularly scheduled airline service to do so (Mueller,
1993, 13).
Bells invention of the telephone in 1876 to the first presidential radio
broadcast in 1929 to network television in the 1950s and voice-over-the-intemet
communications with Kosovar civilians in the midst of Yugoslavias civil war, span
125 years of economic, social and political change for which the power of
telecommunications has been a significant catalyst. Arguably, the convergence of
telecommunications and computing, each extending and in turn extended by the
other is the most important economic force shaping society well into the first half of
56


the twenty-first century. Frances Cairncross (1997, 1) predicts that the resulting
death of distance as a determinant of the cost of communications will alter in
ways that are only dimly imaginable, decisions about where people live and work;
concepts of national borders; and patterns of international trade. Moreover,
governments can delay the most current manifestations of this revolution, but, as
with earlier generations, they cannot ignore or stop it. For some, that translates into
the notion that the best course of action is for the heavy hand of government to just
get out of the way, reverting to earlier, presumably better times when laissezfaire
prevailed. For others, government has been very lenient. That is, some argue that it
has sold out to the vested interests of business in the pursuit of global
competitiveness, leaving its citizens to fend for themselves.
But as Landes (1998, 197) argues, these views constitute history cart before
horse, results before data, imagination before experience and [tjhey are also
wrong. Throughout history, government, even in its earliest manifestation, has
always had an important hand in the development and deployment of
communications technologies. Noam (1992, 7-25) traces the history of the
European system of posts, telephone, and telegraph (PTT) from antiquity to the
Prussian institutional model of a state postal administration adopted in Europe and,
for that matter, most of the world.
The Medes and the Persians had systems for conveying messages that used
human shouts from hill to hill... [I]n the thirteenth century, Marco Polo
described regularly spaced "poste" on China's main roads, where imperial
messengers would change horses ... the Spaniards observed Inca runner
systems in Peru ... in medieval Europe, the origins of commercial postal
service were messenger services run by such disparate institutions as city-
leagues, guilds, religious orders and commercial operators. ... Two forms of
organized postal service emerged. The first was the private service subject to
government authority. ... The second was a state-operated postal service
such as the ones in Prussia and England that became the direct ancestors of
the modern European PTTs.
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In the United States, government has helped establish the privately owned
and operated communications infrastructure in three important ways promotion,
subsidy, and direct intervention (Horwitz, 1989, 49). Owing to the constitutional
protections afforded private property in the U.S., regulation came to be the policy
tool of choice for normalization of the relationship between the privately owned
communications industries and government. It is appropriate, therefore, that a
dissertation focused on telecommunications policy at the beginning of the new
millennium should pay attention to the historical context in which that policy has
evolved.
Tracing the Context of Telecommunications Policy
Lasswell (1971) instructs that all events when viewed contextually provide
insights about those events past, present, and future. According to Torgerson
(1989, 245 emphasis added), a central ambition of the Lasswellian approach to
policy analysis is a contextual orientation that seeks knowledge of the whole but at
the same time does not, from the standpoint of practical application, expect compete
success. Neustadt and May (1986, 251), instructing policy makers in the use of
history for wise decision-making, argue thinking in time requires recognition of
three components. First, the future has no place to come from but the past, hence
the past has predictive value. Second, what matters for the future in the present is
departures from the past, alterations, changes, which prospectively or actually divert
familiar flows from accustomed channels, thus affecting that predictive value and
much else. The third is continuous comparison, an almost constant oscillation
from present to future to past and back (1986, 251).
58


With respect to regulatory agencies, Horwitz (1989, 23) argues that the
essential function of an agency is generally tied to the historical conditions within
which it arises but thereafter its operations become a separate issue dependent
upon the complexities of organizational behavior and institutional constraints.
That is, the dynamic of regulation itself changes over time. Similarly, Friedman (in
Noll, 1985, 129) cautions:
[ljegal arrangements ebb and flow, not in terms of models of perfect
societies or what would happen on desert islands or behind veils of
ignorance but in a messy, noisy workshop of reality ... [w]e must not (as
the literature sometimes seems to do) ignore background, history, context...
[w]e must not treat regulation as something the stork brought suddenly one
night.
And, we ignore the finicky "public" in public policy at some risk. Downs
(1972, 38) argues that "American public attention rarely remains sharply focused
upon any one domestic policy issue for very long even if it involves a continuing
problem of crucial importance to society." According to Downs, the change in
public attitudes, a critical component of pressure for any political action, changes
faster than the environment in which it exists.
With all of the foregoing advice in mind, the remainder of this chapter
explains the fundamental tension inherent in telecommunications policy generally
and then proceeds to place this tension into an historical context.
59


Balancing Interests and Preferences
The telecommunications policy subsystem can be envisioned as a dynamic
search for a balance or stability between the interests and preferences of industry
and those of government. A simple two-dimensional model -- government and
market fashioned after that set forth by Cohen (1992, 17-21) provides a
foundation for understanding the relationship between telecommunications markets
and government oversight. The interests and preferences of industry are represented
by a single corporate actor, Bell, providing one product telephone service. The
other major actor, Government, is likewise unitary, at least for this example,
uncomplicated by decentralized policy making or jurisdictional complexity.
Bell in the last decade of the 19th century emerged as a private enterprise
motivated by profit through the provision of telephone service. By controlling some
portion of the market, Bell could protect some of its profit potential. Markets,
however, are risky and uncertain propositions for competitors. Whether with actual
or potential competitors, Bell sought ways to mitigate risk and uncertainty through
market control and stability. Thus, the first dimension in this model is Bells
preferences for stability and control within the market for telephone service.
Over time, Bells product came to be viewed as a quasi-public good.2 In
legal parlance, it is affected with a public interest.3 As a matter of public policy,
universal access to telephone service is necessary for effective participation in an
increasingly advanced society. The public actor, Government, is the guardian of the
publics interest in universal access to the telephone network. While the public
interest construct changes over time, two fundamental values are juxtaposed in this
policy subsystem: social efficiency and equity.4
60


Social efficiency addresses the question of how much of societys resources
will be spent providing telephone service to its citizenry. Left to the market alone,
telephone service would be priced such that each cost-causer, that is, customer,
would bear the entire cost of all of the telephone service that he or she consumes.
Equity, on the other hand, addresses the question of fairness. Acknowledging that
unfettered markets can be inherently unfair (i.e., there are winners and losers), how
should Government proceed to ensure a more equitable distribution of telephone
service since it is deemed essential to the public interest, convenience and
necessity?5
Public preferences, hence public policy, may be understood as spanning a
continuum with degrees of trade-off between social efficiency and equity whereby
total government control of the market occupies one end and unfettered competition
the other. Again, with Cohens (1992) guidance, we are able to envision the second
dimension of this model as four ideal types of public policy ranging from low
government control to high government control for universal access to telephone
service. Placed on a continuum, the range of government control and its ideal
policy types are defined in Table 3.1.
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Table 3.1
Policy Ideal Types and Degree o f Government Control
No Control ---------------------------------------------------------------> High
Control
Laissez Faire Anti-trust Public Utility Regulation Nationalization
Laissez-faire This policy choice occupies the extreme low end of the continuum. There is no
government control or involvement in the economic sector for telecommunications. This policy
(or perhaps, non-policy) maximizes social efficiency over equity. Thus, there is no mandated
universal service, no low-income assistance and no cross subsidization of rates to accomplish
such goals. The market, i.e., unfettered competition is deemed the best vehicle to protect all
consumers.
Antitrust Within this policy option, modest levels of government regulation ensure a socially
efficient outcome but not necessarily an equitable one.6 This policy option targets all threats to
competition in the name of consumer welfare.
Public Service / Utility Regulation Here equity begins to supersede efficiency in value.
Traditionally, in the provision of telephone service, this policy legalizes and protects a monopoly
provider in exchange for what is referred to as a carrier of last resort obligation (COLR). That
is, there exists a social compact between regulator and regulated in return for protection
from competition and a guaranteed rate of return to shareholders, the company continues to
invest in its network and accepts the obligation to serve all who request service.
Nationalization Positioned at the extreme high end of government control, this policy, in the
name of equity, prohibits the market from functioning altogether. This policy option is generally
not viable in the United States with its tradition of private property. For comparative purposes,
it has, until very recently, been the dominant telecommunications policy in the remainder of the
industrialized world.
Source: Cohen, 1992
The relationship between market and government begins to take shape by
crossing the two dimensions: Bell and its preference for market power with that of
Government with a preference for the mix of social efficiency and equity embodied
in the public service / utility regulation ideal type. From this point of departure, one
can begin to add layers of complexity to the model, affecting the preferences both of
Bell and Government, thus setting in motion the tension between efficiency and
equity that has characterized this long, sometimes stormy, marriage.
62


Significant categories of such effects include
Technological change that first spawns new industries with new competitors
providing new services that over time leads to convergence and
consolidation as well as the demand for equitable access to all things new
and wonderful. In the early years of the 20th Century, all things new and
wonderful meant basic telephone service; at the close of the Century, it
meant access to the Internet and so-called information technologies.
Economic change that throughout the 20th Century tracks with the
commercialization of telecommunications, itself a catalyst for the overall
increase in the standard of living of the industrialized world. In the current
environment, advanced telecommunications and information services are
viewed as synonymous with economic growth.
Political change Jurisdictional oversight protects industrial nation building
activities initially but over time protects competition, not competitors. The
federal legislature initially codifies monopoly, then codifies competition.
Government is not a monolith; political change is, therefore, advocated
unevenly across government agencies and elected bodies.
Social change Patterns of life are changed by the diffusion of technology
and is directly related to universal service policy conflicts. The history of
telecommunications and the evolution of the agencies that regulated it to
follow was, from 1876 until 1984, dominated by one company ~ AT&T.7
What is remarkable about this story, however, is not the invention of the
telephone per se but rather the telephone system. Historian Theodore M.
White commented in an essay published just before the breakup of Ma Bell
in 1984 in the farewell issue of Bell Telephone Magazine that [sjystem is
the word to hang onto as we part... Not the miracles of microwaves or the
miracles of the transistor, nor the coming miracles of fiber glass carrying
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photons at the speed of light can compare to the achievement of making one
system ... . Moreover, as Professor Cherry observes, the development of
telephone exchanges led to the growth of endless new social organizations
because it offered choice of social contracts on demand, even between
o
strangers ... in ways totally new in history.
Political Eras of Regulation
Regulatory historians and students of public administration use a variety of
time-bound designations in which to organize regulatory policy in the U.S (see, for
example, McCraw, 1981; Horwitz, 1989; Cohen, 1992; Vietor, 1994; Safritz and
Hyde, 1992). For purposes of this dissertation, regulatory policy in
telecommunications is aligned with three political eras generally understood to
constitute the major waves of regulatory activity in the United States plus two.
The three familiar political eras are Progressive, New Deal and Great Society. To
these I add two Local Phases. The first is a pre-Progressive Local Phase I because
state regulatory commissions existed before 1910, the date generally identified as
the beginning of the Progressive Era. The other, Local Phase II, is added after the
Great Society and covers the period between the Divestiture of the Bell System and
the 1996 federal Act. For reasons that will become apparent, the most important sea
change in telecommunications regulatory policy that spilled over into local service
regulation and with it, state agencies, followed the break-up of the Bell System
ordered by the Department of Justice in 1982 and implemented in 1984. It is for
this reason we will borrow a phrase from Noll and Smart (1989) and refer to Local
Phase II as "the laboratory of the states." 9
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The Progressive era is generally thought to cover the period 1910 through
the Great Depression. The New Deal era spawned the landmark federal
Communications Act of 1934, the creation of the Federal Communications
Commission and extends through a long period of normalcy in
telecommunications that ensued until roughly the 1960s. During this period, the
regulation of telecommunications was characterized by the acceptance of a policy of
natural monopoly.10 The wave of regulatory activity during the Great Society
occurred when the national economy was plagued by stagflation and immersed in
social crisis. The political irony that arose in this era was one in which an
expansion of social regulation coexisted with the retreat of economic regulation,
albeit unevenly across industrial sectors. Local Phase II (laboratory of the states)
spans the period that begins with the breakup of the Bell system in 1984 and
concludes with the enactment of the 1996 Act and its mandate to deregulate the last
bastion of monopoly in telecommunications local exchange and exchange access
services.11
That which follows summarizes one hundred and twenty-five years of
domestic communications policy. Each section begins with a contextual map
(Lasswell, 1971). Each eras map contains a mixture of significant,
telecommunications-related technological, legal, political and / or economic
benchmarks. Each map, combined with the discussion that follows, is intended to
provide the reader with a reasonable sense of the political see-saw that comprises
the evolution of this industrial sector. No doubt, this approach will raise as many
questions as it answers but, given the complexity of the task, it is unavoidable. The
central lesson, argues Vietor (1994, 315), is that since the intent of economic
regulation is to replicate conditions that would not otherwise occur, it is scarcely
surprising that regulatory effects are eventually unsustainable both economically
and politically. By rearranging the vested economic interests of vendors, suppliers
65


and customers, regulation indirectly changes their political stakes in the regulatory
process itself.
Local Phase I: The Birth of the Bell System and Telephone Regulation
Table 3.2 Contextual Map of Local Phase I
1876: Alexander Graham Bell invents the telephone, first telephone patent issued.
1877: Pennsacola Telegraph Co. v. Western Union Telegraph Company, 96 U.S. 1 (1877).
Supreme Court overturns right of state governments to regulate firms engaged in interstate
commerce.
_____: The Bell Telephone Company is formed.
_____: Western Union sets up telephone subsidiary, challenges Bell patents.
_____: Munn v. Illinois, 94 U.S. 113 (1877). The owner of property clothed with a public interest
is entitled to reasonable compensation for its use.
1879: Out-of-court settlement between Bell and Western Union, first structural division of
electrical communications industry into telegraphy and telephony.
1885: AT&T established as a subsidiary of the American Bell Company to build the long distance
network.
_____: First state commission established for public utilities in Massachusetts.
1890: Sherman Anti-trust Act.
1892: Long distance service established between NY and Chicago.12
1894: The first telephone patent expires.
1907: State-by-state telephone penetration rates first published by the Department of Commerce.
1907: Concept of universal service first articulated by AT&T Chairman, Theodore Vail.
1909: Bell purchases controlling share of Western Union Telegraph Company
Source: Cohen (1992)
The earliest phase of the history of the Bell System is the seventeen years
following Bells 1876 patent grant and is characterized by vertical integration. The
Bell Company, as it was first known, established permanent relationships with local
monopoly operating companies licensed under its patent; a manufacturing arm,
Western Electric, was established; and these two were joined together with the long
distance network constructed by the AT&T subsidiary all in the relentless pursuit
of market power while avoiding the newly enacted Sherman anti-trust law. This
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period of temporary monopoly conferred by the federal government under patent
law is a policy characterized by government protection of a fledgling industry (see
for example, Horwitz, 1989; Stone, 1991).
Once the most valuable patent ever issued expired, however, a period of
intense competition ensued such that by 1904, there existed more than 4,000
independent telephone systems (Horwitz, 1989, Stone, 1991). By 1907, independent
telephone companies competing with the Bell system controlled about 50% of all
telephones (Horwitz, 1989; Vietor, 1994). Bell responded by lowering its rates,
building more plant, and opening new exchanges, thus accelerating the deployment
of the network throughout the nation. Nonetheless, robust competition continued to
flourish, and, as a result, Bells corporate view of telephone service transitioned
from the view of telephony as a limited, expensive service to a relatively cheap,
1 T
potentially universal service.
At this juncture, Bells tactics changed and it aggressively bought out many
independent systems and began to exercise its political influence. By the early
1910s, these actions began to stifle competition. In 1909, AT&T purchased
controlling share of the Western Union Telegraph Company in an effort to increase
its advantage in the long distance market, the linchpin of its ability to dominate
telecommunications.14 Concurrently, the president of AT&T, Theodore Vail, began
to speak favorably of government regulation, arguing that such policy, if
enlightened and uncorrupt, could be a beneficial and stabilizing force for telephony.
Vails oft-repeated slogan, [o]ne policy, one system, and universal service at once
advanced the two-pronged argument that telephony was a natural monopoly and that
technically integrated, end-to-end service was best provided by such a monopoly.
According to Vail,
The Bell company, from the commencement of business, intended to control
the business. The intent is not only claimed by all who were parties to the
management at the time, but it is shown in every record of every transaction
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in the course of business. One system, one policy, universal service is
branded on the business in the most distinct terms.15
During this period, state and local government, especially municipalities,
exercised control over those businesses, including telephone service deemed
affected with a public purpose; 16 thus state agencies sought to construct general
rules for business behavior. This form of government intervention reconciled the
expanding and increasingly complex needs of private enterprise with the democratic
demands for social control and equity. With the expansion of the network such that
it connected politically defined geographic aggregations, oversight by multiple
municipalities gave way to control either by a pre-statehood territorial commissions
or by a single state agency.17
The oversight of business was to be accomplished through the new and
distinctively informal rulemaking. Indeed, prior to 1910, state utility commissions
had sole authority for telephone rate making, because absent a national economy, all
rates were local. State utility (or railroad) commissions were the first to establish
effective control over the hallmarks of economic regulation ~ telephone rates,
market entry, and market exit. It was the states that were on the cutting edge of
the telephone problem in the early 1900s. According to some, to speak of
telephone regulation before 1950 was to refer almost exclusively to state-level
regulation (see for example, Mueller, 1991).18 The Federal Communications
Commission (FCC) by contrast, was not even created until 1934 and did not play an
active role in telephone rate making until the 1950s. Table 3.3 summarizes the
consolidation of local telephone service regulation into a single state agency for the
fourteen states comprising the evidentiary basis for this dissertation.
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Table 3.3 Telephone Service Regulation in Fourteen States
State Agency Date
AZ Arizona Corporation Commission 1912
CO Public Utilities Commission 1913
ID Public Utilities Commission 1913
IA Board of Railroad Commissioners 1878
MN Railroad and Warehouse Commission 1915
MT RR/Public Service Commission 1913
NE Board of Transportation 1887
NM State Corporation Commission 1912
ND Board of Railroad Commissioners 1885
OR Public Service Commission 1911
SD Telephone Commission 1907
UT Public Utilities Commission 1917
WA Railroad Commission 1909
WY Public Service Commission 1915
Source: NARUC Yearbook 1995-1996.
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The Progressive Era
Table 3.4 Contextual Map of the Progressive Era
1910: Mann-Elkins Act brings telecommunication under the ICC.
1911: Negative feedback circuit patented by Edwin Armstrong and sold to Westinghouse Electric
and Manufacturing Company.
1912: Titanic sinks, prompting passage of laws requiring ships above a certain size to carry
wireless equipment.
_____: Radio Act passed. Allocated certain frequencies for government use, required civilian radio
stations to acquire license from Dept, of Commerce. None set aside for broadcast use.
1913: Postmaster General calls for the postalization of telephone and telegraph under control of
the post office.
_____: Simpson v. Shepard, 230 U.S. 352 (1913) court established board-to-board principle.
Court held that all costs of providing local service should be recovered from local rate-
payers.
_____: AT&T purchases deForests patent for the triode vacuum tube.
1914: Kingsbury Commitment. AT&T avoids nationalization; presumption that telephony is a
natural monopoly established.
1914: Clayton Anti-trust Act passed, Federal Trade Commission established.
1917: U.S. participation (through 1918) in WWI, first experiment with nationalization
of infrastructure industry. Telephone industry nominally nationalized.
1919: General Electric / Navy negotiations over sale of the alternator patent by GE to British-
owned Marconi leads to origins of Radio Corporation of America (RCA).
_____: Dakota Central Telephone Company v. State of South Dakota ex rel. Payne, Attorney
General, 250 U.S.163 (1919). Local objection to federally mandated rate increases rejected.
Court ruled that the Postmaster General had the power to set telephone rates.
_____: Telephone wires returned to private ownership, August 1.
1920: Patent pool established between AT&T and GE.
_____: Westinghouse escalates first amateur radio station, KDKA, to full broadcast use.
1921: Willis-Graham Act gives ICC power to approve consolidations and mergers of telephone
and telegraph companies.
1927: The Radio Act of 1927.
1929: Stock market crash, onset of the Great Depression.
1930: Smith v. Illinois Bell Telephone Company, 282 U.S. 133 (1930).Station-station theory of
separations, long distance has to pay some portion of the joint costs of the local exchange.
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Preliminarily, Progressivism was a political reform movement wherein
government incorporated the principles of scientific management, owing to the rise
of the professional classes, into the new, distinct-from-politics area of government
administration (Wilson, 1887; Goodnow, 1900; Taylor, 1911). The Progressive Era
encompasses a period of time that responded to the altered economic conditions
resulting from the advent of the large corporation and the resultant incongruity
between economic and political systems during the transition from a local, agrarian
to national, industrial economy. This transition gave rise to a preliminary, mostly
voluntary form of limited government supervision of industry. This voluntarist
approach (Vietor, 1994), or private regulation (see, for example, Yilmaz, 1998),
existed in an economy that was growing and industry prospering. It was neither
government regulation per se nor laissez faire.19 Stone (1991, 123) argues that "[i]t
was a period in which different conceptions of public policy were dominant in
varying institutions and locations or in which the policy eventually adopted
represented compromise between different conceptions." Socialism, for example,
had a powerful base of support in municipal government, whereas laissez-faire had
one in the court system. Many of the independent regulatory commissions were
dominated by "public service liberalism." During the Progressive Era, policy
related to telephone service was shaped by these competing philosophical
orientations and their respective institutional advocates.
In 1910, the Mann-Elkins Act extended the Interstate Commerce
Commissions (ICC) authority to communications (telegraphy, telephony and cable)
and gave the ICC the authority for interstate telephone rate making. The ICC,
however, remained preoccupied with railroad regulation and did not exercise much
activity in the way of regulatory oversight of telephony during this period. Even
though the states retained authority for local rate-making, it was a period in which
states were consistently overturned in their efforts by a federal judiciary sympathetic
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to the development of national infrastructure industries and with it, interstate
commerce.
Bells anti-competitive actions against independent companies (including a
strategy of beating the competition by purchasing it) and complaints from the
telegraph industry prompted Woodrow Wilsons Department of Justice to move
against Bell in 1913, charging Sherman Act violations. The company successfully
avoided anti-trust litigation and the potential nationalization of telegraphy and
telephony under the Post Office in 1913, under an agreement known as the
Kingsbury Commitment. The terms of this agreement prohibited AT&T from the
purchase of independent companies without prior ICC approval and in no event
could it purchase competitors. In addition, AT&T agreed to let competing
independent companies interconnect with the Bell System. Most important,
however, this agreement established the presumption that local telephony is a
natural monopoly. At the same time, AT&T sought and supported the
consolidation of regulatory oversight from municipalities to single state agencies.
U.S. involvement in World WarI(1917to 1918) resulted in unprecedented
government intervention into the economy and with it, the cross-company use of
patents in support of the war effort. This action, the first significant experiment in
national industrial planning, provided politicians with a preview of the efficiency
and efficacy of such a policy. The benefits of conservative government oversight
were not lost on AT&T's leadership. In 1920, a patent pool was set up for cross-
company licensing mainly for the nascent wireless (radio) industry. While the early
development of radio communications provided the foundation for the broadcast
industry, it also created patent problems between wireline and wireless companies
because each needed the intellectual property of the other to continue technological
innovation. The wireless group included, among others, RCA, Westinghouse and
GE, the wireline group comprised AT&T and Western Electric. Without going into
72


great detail, the pooling of patents by these firms had the practical effect of erecting
insurmountable barriers to entry to any companies that were not party to these
arrangements.
Congress' view of telephony as a natural monopoly was codified in the
Willis-Graham Act in 1921. As such, government intervention should not prevent
monopolization of the industry. Willis-Graham expanded ICC approval powers
over consolidations and mergers of telegraph and telephone companies, which then
permitted AT&T to purchase competing independent telephone companies (many of
which were then clamoring to be bought out). Following on the mandatory
interconnection provisions of the Kingsbury Commitment, AT&T had achieved
virtual anti-trust immunity.
The growth of technological innovation in telecommunications allowed for
the feasibility of long-distance communications and nationwide interconnection.
Social conditions were also altered dramatically because telephony was not just new
technology but entirely new systems of infrastructure, challenging those that had
previously dominated for nearly a century telegraph, mail, and newspapers. The
rapid growth and expansion of telecommunications holding companies fueled by the
technological innovation of entrepreneurs each technological entity and its
respective company luring the other digressed into bitter patent litigation. These
battles and their subsequent resolutions led to legal agreements that provided the
foundation for the structural separations between telephony, telegraphy, wireless,
and broadcast that eventually became the basis for the FCCs regulation of this
entire industry.
Understanding Ratemaking. Because telephony is a service, not a discrete
and measurable product, the value of telecommunications to one customer is
dependent upon the number of people connected to the network.21 The cost to
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connect one subscriber to the network is a so-called common cost. As a result,
from its inception, the interdependence of demand for service led to the cost / value
interrelationship between rate making and socio-political goals of telephone
development. That is, the rates for telephone service should ideally be based on the
value of service and extended to as many subscribers as possible.
The theory of rate making and the practical application of these deliberations
were another matter. The primary issue in pubic utility rate making was (and is
today) the correct valuation of the property of the telephone company. In practice,
this meant endless controversy over the valuation of sunk capital, historical or
embedded costs (see, for example, Kahn, 1970, 39-43). In the telephone industry,
the valuation process was further complicated by the jurisdictional controversy over
the relation between the property, including rates, of the local operating companies
(a.k.a the intrastate jurisdiction) and the property of the parent company (the
interstate jurisdiction).
Once AT&T had become a vertically integrated powerful holding company,
it alone defined these legal jurisdictions. AT&T (the parent company) had control
over (a) the long distance-local rate separations issue; (b) licensing fees paid by the
local operating companies to the parent company, a hefty 4.3% of revenue; and (c)
forced use of AT&T facilities even when the operating companies had parallel,
more cost effective facilities of their own. Generally, AT&T was able to shift costs
and services between jurisdictions and extract revenue out of the local operating
companies. All through the 1920s, AT&T was highly profitable while the financial
situation of local operating companies was, by comparison, far less favorable
(Vietor, 1994). Table 3.5 compares the return on investment of AT&T with that of
the local operating companies between 1913 and 1936.
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Table 3.5 Percentage of Return on Net Book Costs of Plant23
Period Local Companies AT&T
1913-1920 6.22 17.02
1921-1925 7.16 19.21
1926-1930 7.6 13.34
1931-1936 6.02 6.57
Source: Walker Report.
Between market forces and the federal policy inaugurated by the Kingsbury
Commitment, the telephone industry, that is, AT&T, in the pre-FCC era evolved
with implicit government support into a classic monopoly. While AT&T welcomed
government intervention, it was for the purpose of helping AT&T secure its control
over the telephone industry. The only effective control over AT&T in this era was
the Kingsbury Commitment. AT&T had effectively attained the benefits that accrue
to sanctioned monopolies without the quid pro quo of regulatory oversight. This
happy state of affairs was about to change.
The Great Depression. Following the economic prosperity of the previous
decade, the Hoover Presidency (1929-1933) was an incubation period for nations
loss of faith in both competition and limited supervisory government. The stock
market crash of 1929 and the subsequent collapse of the American economy
resulted in wide spread affirmation of the need for more direct forms of government
intervention into the economy generally. A change in political perception regarding
the pyramiding schemes of the large holding companies, jurisdictional confusion
regarding rate making, and a general vacuum of control at the national level sparked
a change in the federal judiciarys attitude toward regulation. This change is
reflected in the Supreme Courts 1930 landmark decision, Smith v. Illinois Bell,
wherein it held that AT&Ts charges to its local holding companies must be
justified in terms of the costs to AT&T for performing the services. This decision
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effectively strengthened state regulation by permitting state utility commissions to
verify the rates charged by AT&T to the local operating entities. Concurrently, the
court ruled that interstate toll rates were beyond the authority of the state
commissions, thus legalizing the necessity for jurisdictional separation of regulatory
oversight and providing justification for the creation of the FCC.24
The Depression caused a major setback in the development of
telecommunications markets. Between 1929 and 1933, the number of telephones in
use declined 18 percent and residential subscribership dropped 25 percent, leaving
less than one-third of all households with telephones. Long distance usage (more
sensitive to income and the level of business activity) dropped 36 percent. The
perception of telephone service as a societal necessity, coupled with a layoff of
150,000 AT&T workers while dividends remained constant, did little to endear the
telephone company to an increasingly economically-challenged public (Vietor,
1989). By 1934, AT&T had consolidated more than 80 percent of the local
network, yielding 90 percent of all local service and 100 percent of the long distance
service; its manufacturing arm sold more than 90 percent of all telephone
equipment. Its position as the worlds largest and most powerful corporation stood
in stark contrast to passive federal regulation (i.e., the ICC) and the lack of
resources among state commissions to effectively control local rates.
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The New Deal Era
Table 3.6 Contextual Map of the New Deal Era
1934: Passage of the federal Communications Act; creation of the FCC.
1941: WWII [U.S. involvement through 1945]. Enormous amount of money spent on
communications, spillover into post war electronics industry, especially microwave
transmission major question whether broad-band was adjunct to wired communications or
a competitive technology.
1944: FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944) at 627. Public interest defined and
standing expanded.
1947: Jurisdictional Separations Manual completed.
1948: FCC reserved permanent use of microwave to common carriers, preserves
AT&Ts monopoly.
1949: DOJ brings Sherman Act anti-trust action against Western Electric.
1951: Separations including subsidy.
1953: FCC v. RCA, Supreme Court upholds regulatory function; maintenance of public interest
means presumption against competitive entry.
1956: U.S. v. Western Electric settled by consent decree.
_____: Hush-a-phone decision, private benefit without public detriment
1959: FCCs Above 890 decision authorized private long distance microwave systems.
_____: President Eisenhower orders NASA to cooperate with FCC (i.e., AT&T) in determining the
structure and utilization of space communications.
1960: Household telephone penetration rate reaches 80%.
1961: Memorandum of understanding between NASA and FCC divides up jurisdiction over
satellite field.
1962: Kennedy-backed compromise resulted in passage of the Communications Satellite Act.
Created COMSAT, 50% owned by existing common carriers and 50% public-owned as
carriers carrier of international traffic only.
The principal economic policy prescription of Franklin Roosevelts New
Deal addressed macroeconomic failure (insufficient aggregate demand,
unemployment, and deflation), with a series of microeconomic tools, including
industry-specific regulation (Temin, 1989). FDRs seeming solution was not the
restoration of competition (i.e., the goal of Progressive Era reformers) but rather
77