Competition in the Long-Distance. Telecommunications Industry

Transcription

1 Competition in the Long-Distance Telecommunications Industry Industrial Organization and Pricing Thursday, May 1, 1997 By Robert Koch

2 Introduction The Telecommunications Act of 1996 has been in the focus of many economist for over a year. At issue is how to induce fair competition in the industry. one of the most relevant tools that will be needed is an effective measure of competition in the market. This is so that regulators will know when to back-off and let the market take over. This is not a new issue. The break-up of AT&T in 1984 and the ensuing regulatory methods placed on AT&T in the long distance market have been examined extensively in the literature, as well as before the FCC and FTC. Of importance to regulators is the extent of market power the incumbent has, and the effect on society of their actions. Recently AT&T was declared non-dominant by the FCC. However, this occurred over a transition period. Before deregulation could be completed, it had to be shown that they did not exhibit market power. The literature on the long distance market thus focuses on AT&T s pricing behavior and performance mainly. It is rather interesting to consider what model most appropriately fits the long distance market. In 1984 it was almost exclusively a monopoly. With the entrance of MCI and Sprint, and divestiture, the market has changed. The transition started obviously as a dominant-fringe relationship. However, AT&T was a dominant carrier that had the restriction of government regulation while the other two were free to make contracts and have flexible pricing. Another intricacy is that the form of regulation changed from a Rate-of-Return to a Price Cap scheme. Thus, AT&T was able to be more flexible with their more lucrative customers.

3 As the other two carriers started to mature, AT&T s market share and hence their ability to dictate prices declined. The question also arises about collusion in long distance prices since their are few firms. Not only is it possible that AT&T effect the pricing of other firms naturally due to the structure of the market, but agreement to keep prices above costs by the three firms needs to be considered before their is competition. Thus, it is not only AT&T that needs to be considered at this point, but the response of the other companies to them. The long distance market itself has evolved. During the transition the new entrants actually offered a slightly different product. The new entrants built using the technologies of the 1980 s, while AT&T was using technologies of the 1960 s. This effects the market in a number of ways. The foremost of these is cost. That is, the new fiber networks and digital switching equipment was cheaper to operate. Another is the quality of the connection. Fiber sounds better and has more bandwidth. When a fiber network has a problem it can re-route without dropping the call. AT&T had to play catch up to match this difference. Now, all three networks are made of fiber almost exclusively and quality differences are minimal. The structure of this paper is to present the findings of those in the industry as to the state of competition in the industry. William E. Taylor and J. Douglas Zona, An Analysis of the State of Competition in Long Distance Telephony Markets The authors feel that their is not adequate competition in the long-distance industry. The authors concede that there has been a radical change in the statistical

4 nature of the market since divestiture. However, the point out that it is erroneous to conclude on market share alone that there is effective competition. The study is empirical in nature and seeks to quantify measures of behavior in the following seven categories: 1. Relative price performance: looks at how reductions in access charges have been passed on to consumers. 2. Pricing behavior: studies that the amount of market power in the industry through firms ability to raise prices profitably. 3. Productivity: looks at how productivity growth in this industry compares to historical rates. 4. Quality: seeks to find if firms are competing in quality. 5. Advertising: is advertising improving the information available on varying plans or is it an efficiency loss? 6. Entry: looks at what barrier to entry may exist and evidence of entry by firms seeking profit. 7. Financial performance: examines whether long-run profits are moving towards zero. As far as relative price performance is concerned, AT&T is examined on the basis of per minute margins. What is found is that prices have been reduced dramatically as well as them losing significant market share. However, access charges play a large part in this reduction. Access charges fell by 50% since 1984 but prices have not matched the reduction. Since the firms costs have reduced by more then prices, the actual margin has increased since divestiture.

5 Pricing behavior is found to be non-competitive for AT&T. With regulated price caps there is little to suggest that they have full power to set prices. However, the study appears to reveal coordinated pricing amongst competitors. The results for productivity are mixed. The authors looked at total factor productivity. What they found is that there is no long term trend in productivity growth. They are unwilling conclude that this illustrates evidence of non-competitiveness in the market, though. They concede that technological improvements may have been slower after divestiture. The examination of quality is rather basic in comparison to the analysis of the other criteria. The level of blockages in services due to equipment failure is compared for areas where there is more competitive pressure as compared to those where there is less pressure. What is shown is that there is no significant difference in quality where competition is more prevalent. The effect of advertising is measured by the annual rate of churn in the industry, i.e. the rate of switching between carriers. The rate of switching customers is high, at 19%, and indicates that consumers are not being informed properly. The shear increase in advertising expenditures is consistent with product differentiation as well. This is typical behavior of highly concentrated industries. Advertising on a national scope also has the anti-competitive effect of raising barriers to entry. That is, only large firms can match the scope of advertising that the incumbent companies produce. The study of entry shows that many firms have entered the long-distance market, mainly as resellers of AT&T, MCI and Sprints products. The authors conclude that this is not evidence that there are few barriers to entry but rather that there are economic

6 profits to be had. The effect of entry, it should be noted, has not had the effect of lowering prices as theory would suggest for competitive markets. In examining financial performance, earnings per share of stock and price-cost margins are looked at. Both of the measures have increased since divestiture. Thus, financial performance is not consistent with competition theory either. Peter W. Huber, Telephones, Competition, and the Candice- Coated Monopoly Huber s approach to examining competition in the market is different then that used by Taylor and Zona. His analysis of divestiture concludes that the antitrust courts and regulators have viewed the nature of the long-distance and local telephony markets incorrectly. That is, he believes that the long-distance market is in fact best served by a monopoly and that the potential for competition exists primarily in local markets. Huber s main theme is that regulators and courts have misinterpreted the technical nature of each of the markets. Not only did they do this at divestiture, but their actions since World War II have also been contrary to effective competition in markets. Microwave technology was developed during the war. The author states that true competition could have occurred in the 1950 s as this technology emerged but that AT&T was protected at that time. As a result, competition in this market using microwave technology didn t occur until the 1970 s. The technology now available in the long-distance market is fiber-optic. The author argues that one fiber network can handle all the long-distance traffic and that there is excess capacity in the system currently. What we have is a scenario in which fixed

7 costs are high relative to marginal costs and thus this is a declining cost industry. In this case, a natural monopoly scenario exists and it can be argued that one firm would be more efficient then many. The author argues that AT&T has a cost advantage due to it being the largest long-distance network. That is, it is cheaper to provide access to AT&T by the local exchange companies but the problem is that all carriers must be charged equivalently for access. According to the author the cost savings would be from 16% to 40% of what the competitors costs are. The fact that the equal access requirement exists keeps AT&T from emerging as the most efficient single provider of service. The threat of further antitrust and regulatory hassles keeps AT&T from contesting this rule. If AT&T were allowed to once again be the monopoly provider, there would be re-regulation of it s services. As it is, AT&T stands to gain from being allowed in to other markets as it is officially considered a competitive interexchange carrier. The sentiment of the author is that what appears to be competition actually isn t. Huber refers to the market as having umbrella pricing. The regulatory battle in price cap regulation has been to keep AT&T from lowering prices and competing naturally. This argument is supported by references of any kind. Another point make is that even AT&T doesn t have an incentive to be reregulated. He points to AT&T s statement that their prices are falling for services due to competition. What has happened, though, is that reduction in access charges have been the main cause of price reductions rather then the company passing savings on to customers. If the reduction in access charges is removed, the actual reduction in prices charged by the company are not significant and do not match the actual cost savings from

8 improved technology. Since 1984, access charges have decreased by $10 billion while annual prices fell only by $8 billion. Paul W. MacAvoy, The Failure of Antitrust and Regulation to Establish Competition in Long-Distance Telephone Service In this text, MacAvoy looks at price-cost margins to find evidence of competition. This study states that price competitiveness in markets where market concentration of sellers is declining is marked by declining prices and profit margins. The text goes in to great detail explaining its methodology for determining profit margins and looks at the industry in major markets were competitive pressure should be greatest. The author establishes firstly that market concentration is in fact declining. The structure-performance relationship is key to the analysis. What MacAvoy found is that price-cost margins were actually increasing in this industry since as concentration decreased, which goes against theory that states that they should move in the same direction. Another consideration that the author makes is that the nature of tariff filings has allowed the big three competitors to coordinate pricing. Basically, AT&T had to file tariffs before the FCC before MCI and Sprint had to. The opportunity existed for the two smaller firms to follow AT&T s lead. The results show that quite often the carriers followed AT&T s lead on pricing decisions. What this means is that the ability to coordinate prices existed and that the competitors behavior has been consistent with the behavior.

9 Michael R. Ward, Measurements of Market Power in Long Distance Telecommunications Michael Ward produced this document at the Federal Trade Commission. His analysis is considerably different then that of the authors previously mentioned for a couple of reasons. His analysis concludes that there is effective competition. Also, his methodology is to find actual demand elasticities to form a conclusion. Ward s reasoning is that demand elasticity in a perfectly competitive industry is infinitely elastic due to firms facing horizontal demand curves. He assumes that residential and small business customers use a two step approach to purchasing decisions for long-distance service. Initially the individual estimates their own usage and then chooses the carriers based on price. He uses data taken over the period from 1986 to His results show that demand elasticities, although not infinite, are fairly high. AT&T enjoys a lower elasticity then the competitors (between -5.3 and -6.3 for AT&T and between and for competitors). This gives credence to the fact that an alteration of price does effect the share of the market considerable. That is, market power is decreasing for AT&T over this period. Another facet of this analysis takes a look at dead weight loss in the market. Obviously, the less dead weight loss that there is implies that the market is more efficient and hence more competitive. In the early days of divestiture there was not sufficient pressure on AT&T from the market to keep prices down. However, the results form the period 1988 to 1991 show that dead weight loss was between.03% and.36% of total

10 revenues for the industry. This is evidence that pressure on prices exists in the market to remain close to marginal costs. Summary The various studies provided here show that there is more then one method of looking at competition in industries. The conclusions that are reached can be very dissimilar as well. It is beyond the scope of this paper to examine the relative merits of one study over another. Regulators in this industry are charged with deciding what factors are important in the analysis based on their own judgment. The fact that AT&T s prices have been completely deregulated shows that the government feels that there is sufficient market competition. The introduction of the Telecommunications Act of 1996 shows that the government believes that markets are at a point were oversight is not the best method of dealing with the industry.

11 References Huber, Peter W., Telephones, Competition, and the Cadice-Colored Monopoly, Cato Institute, MacAvoy, Paul W., The Failure of Antitrust and Regulation to Establish Competition in Long-Distance Telephone Service, AEI Press, Taylor, William E. and J. Douglas Zona, An Analysis of the State of Competition in Long-Distance Telephone Markets, National Economic Research Associates, Inc., May Ward, Michael R., Measurements of Market Power in Long-Distance Telecommunications, Federal Trade Commission, April 1995.