Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  Congress gave more clarity to the regulatory mission when it created the Federal Communications Commission, giving that agency authority to ensure that the rates telephone companies charged were “nondiscriminatory” and at such a level to ensure service would be universally available (an obligation that came to be called “universal service”). State regulators oversaw the rates charged by the individual “operating companies’ within AT&T’s network. In combination, the federal and state regulatory regime eventually helped meet the universal service objective by keeping the rates of interstate calls high in order to subsidize local telephone connections for urban and suburban customers. Independent telephone companies (of which there were as many 1,500 as late as the 1980s) served primarily rural areas.

  In 1949, the Justice Department filed another antitrust case against AT&T and its equipment manufacturing company, Western Electric, for excluding competing equipment companies from selling to AT&T. The department wanted Western Electric spun off from AT&T, while obligating AT&T to buy its equipment on a competitive basis. The department sought this relief in order to give other equipment manufacturers a chance to compete.

  AT&T responded that its vertical structure was necessary to protect the “integrity of the network,” and also was essential for national defense, arguments the company would invoke when it was sued by the government again 25 years later. The 1949 case was settled in 1956 with another consent decree, which allowed AT&T to retain ownership of Western Electric, but limited the company to making only telephonic equipment. The decree also limited AT&T to providing “common carrier” services, which meant it had to stay out of the computer, radio, TV, and motion picture industries (sectors the company either already had gotten out of or never entered in the first place).4 The case was not about AT&T’s control over long distance and local telephony (except in a few geographic areas of the country, mostly on the west coast and in Florida, where General Telephone & Telegraph had a significant presence). Within the Justice Department, many staff attorneys for years viewed the settlement as a sellout.

  Ultimately, AT&T’s monopoly in both long distance and equipment manufacture was undone in the 1980s by the Justice Department, with prior help from other parts of the federal government that, beginning in the Johnson administration, had been looking at ways to introduce more competition into the telecommunications industry. Equally, if not more significant, continuing technological advances in voice and data communication—including mobile telephony and the Internet—have essentially eliminated the vestiges of AT&T’s claim to natural monopoly, especially in local landline phone service.

  Though lawyers were critical to the government’s final antitrust case against the company, ultimately forcing its breakup in 1984, economists played an important, but too easily forgotten, role before the case was launched and as it was proceeding. You’ll learn how in the next section.

  Finally, economists were central to inventing and promoting the use of a different form of price regulation of monopolies—incentive regulation” or “price caps”—in both the telecommunications and electric utility industries in the 1970s and 1980s. This new system differs from the standard practice up to that time of allowing monopolies to charge prices sufficient to guarantee them a given rate of return on their invested capital. Although price regulation is much less common today than it was then, price caps generally accomplished their main objective—encouraging greater efficiencies by regulated monopolies—and we have economists to thank for that outcome.

  When Natural Monopolies End: The Run-Up to the AT&T Antitrust Case

  AT&T’s “natural” monopoly became “unnatural” because of a series of technological advances—microwave, satellites, and cellular transmission—that first changed the economics of the market for voice and data transmissions across state lines, and then obliterated the monopolies of the regional remnants of AT&T in local telephone markets. But technology could not do its magic without facilitative public policies. It is in this realm that economists helped push competition along at critical junctures, although admittedly, technologists and lawyers played the leading roles.

  The first part of the AT&T network to crack was its monopoly over all equipment required to deliver telephone service, beginning with the telephone itself in the customer’s hand, where claims of natural monopoly were weaker on their face than in the transmission lines and switches that routed calls.5 The triggering event was so trivial and even laughable—AT&T’s refusal in the mid-1950s to allow a cup-like device called the “hush-a-phone” to be attached to the telephone on the grounds that it threatened the integrity of its network—that, looking back, it is difficult to take seriously. But AT&T was deadly serious about it, fearing that any crack in its equipment monopoly would lead to others. The company’s main regulator, the FCC, amazingly agreed with AT&T’s refusal to allow its customers to use this simple device, but the Commission’s decision was eventually overturned in the courts.6

  AT&T was right, though, to fear the slippery slope of competition that further innovation would unleash. A little more than a decade after the fight over the hush-a-phone, in 1968, another company wanted the FCC’s approval for a “Carterfone,” a device that connected a telephone to a two-way radio. This time the commission showed that it had learned its lesson and gave its green light.

  The commission went further, on its own initiative. In 1975, it issued “Part 68” rules that detailed how other equipment manufacturers could sell telephone-related equipment to the public without having to install special “coupling devices” to protect the integrity of the network. These rules also required AT&T to cooperate to ensure the supplementary devices would work (the company’s failure to cooperate on other matters, principally interconnecting with long-distance competitors, formed the heart of the government’s antitrust case against AT&T, to be discussed shortly). Those rules were worked out with the cooperation of the Antitrust Division at Justice and telecommunications experts in the White House.

  The commission also issued a series of orders in the 1970s and 1980s requiring AT&T to sell equipment through a separate subsidiary and to “unbundle” the offering of that equipment from telephone service. In theory, these requirements were designed to prevent the company from playing games with its cost allocation between telephone service and equipment sales, while allowing customers the ability to choose telephone and related equipment from other providers. In practice, the settlement of the antitrust case would replace these regulatory attempts to inhibit AT&T’s ability to frustrate competition.

  As important as it was, the competition to AT&T’s manufacturing operations did not really threaten the core activity of the company, which was to provide end-to-end telephone service from anywhere in the country. When the company’s leaders invoked the need for its monopoly to “protect the integrity of the network,” this is what they were talking about.

  Yet the network was not indivisible. While the company’s local lines and switches arguably still constituted a natural monopoly because there really was no other way, yet, to complete local calls or to route long-distance calls to their local destinations, one pesky upstart, a small company called Microwave Communications Inc. (“MCI”), began in the 1960s to test the natural monopoly thesis in AT&T’s long-distance or interstate calling market by rolling out its own microwave towers to compete with AT&T’s. Ma Bell’s pricing structure, with long-distance rates approved much above cost in order to subsidize local service, attracted such entry. So it was only a matter of time before companies like MCI sprang up to chip away at the most vulnerable part of AT&T’s empire. Knowing this, and understanding that competitive entry into long-distance would be like pulling a thread in a sweater only to eventually see the whole garment unravel, AT&T fought MCI in the marketplace, before the FCC, and later in the courts.

  MCI began seemingly innocently enough in the late 1960s by offering private lines to businesses that wanted to transmit voice and data between their different locations (televi
sion broadcasters had constructed private lines for themselves years before, but MCI was the first firm to sell private-line service to third parties). The FCC approved the company as a “specialized common carrier” to offer this service. MCI did not stop there, however. Through successive petitions in the 1970s, it gained the commission’s approval first to connect to AT&T’s network at the organization of a voice or data transmission, and later at the point of termination. Ultimately, MCI was selling its long-distance service not just to businesses for private-line service, but also to residential customers. To accomplish all this, MCI bought bulk service from AT&T at discounted rates because of its heavy call volume, and then resold the service at a higher price to MCI’s customers. In essence, MCI was taking advantage of AT&T’s volume discount, coupled with MCI’s own growing microwave transmission network, to compete directly with AT&T in the long-distance market.

  Not surprisingly, AT&T did not take this arrangement lying down, refusing to interconnect with MCI and even unplugging MCI’s private lines.7 AT&T defended itself by arguing that not only was MCI unfairly “cream skimming” AT&T’s customers but, in doing so, it was undermining the ability of the AT&T system to ensure universal service through the subsidy of its long-distance. AT&T had made similar arguments in the early 1960s, when it wanted to counter the competitive threat posed by private line suppliers, by offering its own TELPAK service, but at prices at low incremental costs. The FCC rejected this attempt, largely on the grounds that such prices could drive private line competitors out of business, and once that happened, there was no way for the commission to guarantee that ATT’s incremental cost-based prices would remain so low.8

  Even before all these events played out, the Johnson administration began an inquiry into the need for competition in telecommunications markets generally. In 1967, it formed a Task Force on Communications Policy, chaired by Eugene Rostow, the former dean of the Yale Law School who was then serving as Undersecretary of State for Political Affairs. It also included representatives from other federal agencies and the president’s Council of Economic Advisers (CEA). The general counsel of the task force was the young Richard Posner (yes, the same Posner I discussed in Chapter 5, who later became one of the nation’s leading legal scholars and judges), whose recollections of its work I draw on here.9 Of particular importance to the thesis of this book, the task force had three distinguished economists working on it; one fulltime, Leland Johnson, and two representing the CEA, Merton “Joe” Peck, a member of the Council, and then senior staffer Roger Noll (the same Roger Noll I referred to in the introduction to this section).

  In Posner’s words, Leland Johnson (no relation to the president) had already achieved “a measure of academic celebrity” for what was called the Averch–Johnson effect—the incentive of price-regulated firms to over-invest because they can recover a rate of return on capital investment in their regulated rates.10 I will have more to say about this well-known effect in the next section. Joe Peck was one of the nation’s leading microeconomists, and Noll later would become one, too, as well as a widely recognized expert in telecommunications economics and policy, among many other topics (sports economics, for example).

  Donald Baker, who would later head the Antitrust Division at the end of the Ford administration and in the early part of the Carter administration, was the Justice Department’s representative. Though Baker is an outstanding lawyer, he worked closely with economists inside and outside of the department (see the discussion in the next chapter about fixed brokerage commissions) and appreciated the importance of their thoughts and contributions.

  The task force had a broad mandate that went beyond the future of AT&T’s monopoly, including developing policies for cable television, then a fledgling part of the television market, and satellite communications. Toward the very end of President Johnson’s term, the task force issued its report, recommending more competition in satellites, but little more. According to Posner, although the task force was skeptical about the social value of maintaining AT&T’s monopoly and wanted more competition in telecommunications,11 its final report did not advocate a major shift in policy toward the company.

  Nonetheless, just by suggesting that more competition was important—the predilection of the economists—the task force encouraged the FCC and the Justice Department to open the edges of the telephone network to competitors, and help worked out the rules to facilitate this. The intellectual groundwork plowed by the task force also helped Justice to eventually decide that rules alone weren’t enough. AT&T simply had to be broken up so real competition in telecommunications markets could really take root.

  However, no agency of the federal government, including Justice, can simply order a company’s breakup. Under the antitrust laws, specifically Section 2 of the Sherman Act of 1890 that prohibits monopolization, the government must file suit in a court of law and convince a judge or a jury that a company has monopolized one or markets in an unlawful way and that these misdeeds are so egregious that a simple injunction against their repetition is not enough to prevent them from happening again. The government must convince the courts that only “structural relief” can ensure competition going forward.

  That is exactly what Justice decided to do in November 1974 when it filed its landmark monopolization case against AT&T. Justice’s core complaint: that AT&T was using its bottleneck monopoly in local telephone service to force customers to buy telephone equipment and long-distance service, thereby frustrating competition in both of these latter two markets. This was not a “big-is-bad” case, as some critics alleged at the time. Rather, the AT&T case was all about the abuse of monopoly power in one market (local telephone service) that prevented competition in adjacent markets (equipment and long distance).

  The department did not come to its decision lightly; its lawyers, economists, and engineers spent several years reviewing mountains of internal material obtained from the company and other external evidence.12 In launching the case, the department rejected AT&T’s core defense: that maintenance of its monopoly was essential to protect the integrity of its network and to ensure universal service. AT&T also claimed that its monopoly was essential to the national defense, and even had the Defense Department convinced of this view.13

  Economists inside and outside the Antitrust Division played an important role in the deliberations that led to the complaint. Within the division, chief economist George Hay was asked by then Assistant Attorney General Thomas Kauper to review materials relating to AT&T’s activities, which he did with Bob Reynolds, an economist Hay had recruited to the division that year. They concluded, in a memo simply titled “Bell,” written primarily by Reynolds, that from an economic perspective it was desirable and feasible to separate AT&T’s local, equipment manufacturing, and long-distance operations. Separately, unbeknownst to the economists, the division’s legal staff had opened two separate investigations into the company’s conduct in the long-distance and equipment markets. Once the various parts of the division were aware of each other’s efforts in early 1974 they began to interact. Hay recalls that one of the main contributions of the economists was to convince the division’s leadership that only divestiture would prevent future anticompetitive conduct.14

  Outside the division, Bruce Owen, currently a professor at Stanford, wrote an influential memo (which eventually found its way to the antitrust division) while serving as chief economist of the newly created Office of Technology Policy (OTP) and later as a consultant upon his return to Stanford, advocating what would become a main objective of the case: the divestiture of equipment manufacturing and long-distance operations from AT&T’s local telephone monopolies. OTP was established inside the executive office of the president on the recommendation of the Johnson task force (the office was later abolished in the Ford administration and its duties were transferred to the Commerce Department).15

  The government and AT&T spent eight years in discovery and litigation arguing the merits of their respective positions, befo
re reaching an approved settlement in 1982. Once the complaint had been filed and the trial was under way, the division’s lawyers and economists (who also were in frequent contact with their counterparts at the FCC) were largely separated, though the latter continued to have input into the case, primarily about relief. The settlement was reached toward the end of the trial, and was driven by the Assistant Attorney General for Antitrust in the Reagan administration, William Baxter, who was on leave from his law professorship at Stanford Law School. Although not a professional economist, Baxter, like many law professors who taught and wrote about antitrust law, clearly thought like most microeconomists who presumptively favor competition. He believed that firms subject to rate-of-return regulation should not be allowed into other unregulated businesses, and he frequently asked his top staffers as the case was proceeding and as relief was being considered, “What do the economists think?”16

  Baxter convinced AT&T that it was likely to lose at trial, and that it would save time and money to settle the case essentially on the terms of the original complaint: by agreeing to a breakup of the company that separated its long-distance business, which remained as part of the old AT&T, from its local telephone and equipment businesses. Local telephony was split into seven “regional Bell operating companies” or “RBOCs” as they came to be known, while the equipment company became Lucent, which also took the research and development gem of the old AT&T, Bell Labs. Because the RBOCs each still had monopoly power in local landline service, they also were subjected to a nondiscrimination requirement: Each had to deal fairly and on the same terms with all long-distance and equipment competitors, including both the former constituent parts of AT&T and any existing and new rivals.