Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business
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Baxter almost never got a chance to settle the case on its original terms. While the case was being tried, Secretary of Defense Weinberger and Secretary of Commerce Baldrige, along with Presidential Counselor (and later Attorney General) Ed Meese led an effort within the Reagan administration to persuade the president to end the case by supporting legislation that would require Bell’s operating companies to provide equal access to all long-distance companies. Baxter was strongly opposed to this notion because it relied too much on regulation and, in any event, would never have made it through Congress. Baxter and his opponents had a showdown at a cabinet meeting with the president in 1981 (Baxter’s boss, Attorney General William French Smith, was recused from the AT&T case because of his prior board membership at Pacific Telephone & Telegraph, a Bell operating company). For all its theatrics, the meeting ended inconclusively. In the end, the matter was delegated to then Chief of Staff James Baker who decided that the political benefits for the President to stop the case were not worth the cost.17
Baxter also never would have been in a position to settle the case on such far-reaching terms had the Carter administration reached a settlement earlier. Toward the end of the Carter term, the Assistant Attorney General for Antitrust, Sanford Litvack (who had replaced John Shenefield, who served in that post earlier in the administration), and his legal staff were considering a settlement that would have allowed AT&T to keep its long-distance operations, while divesting a few operating companies and a portion of Western Electric. Inside the Division, Bob Reynolds and Bruce Owen, who was then serving as chief economist, strongly objected that such a settlement did not go far enough by omitting the divestiture of all of AT&T’s multiple local operating companies from AT&T’s long-distance division. According to one popular account of the incredible twists and turns in the case, Litvack came very close to settling the case, even after Reagan was elected, and until Baxter was named as his replacement.18 It is not clear whether it was Litvack or Baxter who called off the settlement negotiations in early 1981, but the outcome then and later was consistent with what the economists had been pushing all along—full breakup.19 For reasons I discuss next, history will judge both the decision not to settle “on the cheap” in 1981 and Baxter’s decision the following year to press for the larger divestiture that included the spinoff of AT&T’s long-distance operations as two very fortunate outcomes.
In the end, it is difficult to apportion credit among the many public servants who made the breakup of AT&T possible, and thus the social and business benefits that breakup achieved. However, it is clear that various economists played important roles, especially at the beginning in framing the case and the desired relief so broadly, and in continuing at appropriate times to press that vision on the attorneys who were in charge of the case.
Competition in Telecommunications: The Benefits of AT&T’s Breakup
In the two decades following the breakup or the “divestiture,” mergers among the RBOCs eventually reduced their number to three, one of which, Southwestern Bell, eventually bought the “old AT&T” long-distance company (post-breakup) and thus became the “new AT&T.” The other surviving RBOCs were Verizon and Qwest. While consolidating the local landline exchange industry, these mergers did not enhance the market power of the resulting companies in their local markets which were already monopolized. In theory, the mergers reduced the potential competition that each RBOC could have provided in the long-distance markets outside their territories (which the 1984 breakup consent decree allowed). But over time, technological advances coupled with entry of new firms turned all of telephony, long-distance and local, into far more competitive markets than many may have thought possible at the time of the breakup.
Take long-distance first, where a main objective of hiving off the local telephone monopolies from AT&T’s long-distance business was to give other firms in long-distance a fair shot at competing. That is exactly what happened. MCI and Sprint, a follow-on upstart, not only made inroads into the long-distance market, but they each built out new fiber optic networks, compelling the “old AT&T” to do the same. Although these networks had high fixed costs, with their enormously increased capacity to carry voice and data signals at essentially zero marginal cost, they induced vigorous price competition in long-distance, which drove down calling rates.
Even more important, the new fiber optic networks in the United States and overseas ultimately became the backbone of the Internet, which has totally transformed telecommunications and indeed the way of life in modern and developing societies alike. I recall one meeting in which I participated sometime in 1994, while serving as a Deputy Assistant Attorney General in the Antitrust Division, with senior officers of Corning Glass, a major manufacturer of fiber optic cables. They told us that had it not been for AT&T’s breakup, their company never would have been able to sell as much, or any, fiber optic cable to Sprint and MCI. Both these companies, in turn, built out fiber optic networks, which became part of the Internet’s backbone.
We will never know, of course, if the Internet would have developed at the same pace had AT&T’s long-distance monopoly never been opened up to competition, but the presumption has to be that the breakup accelerated the pace of change. The best evidence for this is that although the fiber optic cables that constitute the Internet’s basic infrastructure had been invented in Bell Labs, the parent company did not really roll out the technology until competitive pressures forced the AT&T long-distance company to do so.20 In addition, the earlier 1956 AT&T consent decree and later regulatory decisions by the FCC in its “Computer I” and “Computer II” decisions forcing that company and GT&E to offer packet switching services through separate subsidiaries meant that when the Internet and its packet switching technology came along, that technology was built out by companies that were separated from the dominant telecom providers. This buttressed competition in the packet switching market that also helped accelerate the commercial build out of the Internet.21
The competitive race to build fiber networks had profound implications for many, now iconic American businesses. Companies like eBay, Amazon, Facebook, and Google, let alone their counterparts abroad, especially in China, owe their existence to the Internet. Each was founded by one or more innovative entrepreneurs who implemented their ideas at the right time in their careers. As Bill Gates has said of Microsoft’s success, “Our timing in setting up the first software company aimed at personal computers was essential to our success.”22 Had Gates been born even one or two years earlier or later, he might never have formed Microsoft, while Apple’s closed operating system might have achieved much greater success than it did. Likewise, had the build out of the Internet come several years later it is entirely possible that one or more of the Net-based companies that are now household names never would have launched. In some respects, then, these businesses and their founders may have the breakup of AT&T to thank. Economists who played some role in the events and decisions that ultimately led to AT&T’s dismantling also deserve some of the credit.
The other great post-breakup development was the introduction and explosive growth of mobile telephony, which, among other things, ultimately undermined the core monopoly of the old AT&T and its local landline telephone services. Of course, the lion’s share of credit for the mobile telecommunications revolution goes to the technologists at Bell Labs who developed the system of cellular communications based on the transmission of microwave signals between cell towers in widespread use today. After trying out the system in the late 1970s, the old AT&T received the first license in 1982 from the FCC for widespread commercial use of a portion of the electromagnetic spectrum for cellular telephony. As part of AT&T’s breakup these licenses were distributed to the seven RBOCs. In retrospect, it is somewhat amazing that the new AT&T long-distance company did not ask Justice for permission to keep the cellular licenses, which would have done more to promote landline versus wireless competition than vesting the licenses with the RBOCs. Justice probably would have granted
such a request, but it was not forthcoming.23
The FCC also handed out one other cellular license in about 100 local markets by lottery so, for over a decade, cell phone service in each area was a duopoly. As long as this was the case, mobile phone service, which was much more expensive than landline service, provided only limited competition to the RBOCs’ own local landline monopolies. Some of the winners of the lotteries, meanwhile, turned the licenses into fortunes. Craig McCaw, in particular, assembled a national network of licenses by buying other winners, ultimately selling his McCaw Communications to the “new AT&T” in 1994 for over $11 billion. McCaw later went on to rejuvenate and sell Nextel, and later to purchase Clearwire, subsequently bought out by Sprint Nextel, which has become a major wireless broadband provider.
Broadband Communications in the Internet Age
What has made the Internet so ubiquitous and useful is the increasing speed of the communications that broadband providers made possible. As a result, what constitutes “broadband” Internet service has been and continues to be a moving target.
Internet service speeds are measured by the number of bits, or digital zeroes and ones, of voice or data per second that are able to travel through the Internet. The constraining factor is not the long-distance fiber optic cables that can carry bits at the speed of light, but the “last-mile” connection to a customer’s premises. In the early days of the Internet, customers were limited to the copper wires of the telephone network that ran into their homes, and thus could only communicate through dial-up modems that carried messages at speeds measured in the tens of thousands of bits. Over time, these speeds increased greatly, as coaxial cables, upgraded telephone (digital subscriber or DSL) lines, and even fiber-optic cables—each a form of broadband—have been connected to homes and businesses.
At this writing, minimum broadband speeds, as defined by the FCC, are 4 million bits per second (Mbps) for downloading information from the Internet, and 1 Mbps for uploading data. As of early 2013, more than 90 percent of U.S. households had access to landline broadband connections, and most of the rest were able to buy broadband services from wireless providers.24
Broadband speeds will continue increasing over time. Already, much of America has access to landline service with average download speeds of 15–20 Mbps, far faster than the FCC-defined minimum. Google has been rolling out in selected cities its “Google Fiber” connections with speeds of 1,000 Mbps, or 1 gigabit.
As speeds increase, the number and variety of applications proliferate. As just one example, video streaming of television shows and movies, which only a few years ago was a pipedream, has made huge inroads into the entertainment market, posing a significant competitive threat to cable-based television. Real-time video transmission has made telemedicine and remote surgery possible, and online videos on demand have begun to revolutionize education at all levels. The possibilities for other broadband applications seem limitless.
Economists played an important, though largely unseen, role in the subsequent explosive growth of cellular telephony in the United States through many years of advocating the auction of licenses to the electromagnetic spectrum in lieu of more lotteries or administrative decisions (the way the FCC handled radio and television licenses). The details relating to the auctions will be discussed in the last section of this chapter.
At this point, however, I only want to highlight the importance of the auctions in expanding the number of competitors in mobile communications, which has brought down rates over time and improved quality of service. With a duopoly in cellular service in each service territory, neither one of the providers had strong incentives to compete on price or quality. This changed when the FCC launched its personal communications services, or PCS, broadband auctions in 1994, after Congress gave it broad authority to do so in 1993 (for a definition of broadband, see the preceding box in this chapter). When it began its auctions, which have continued intermittently in the succeeding two decades, the FCC accepted bids for 99 licenses, two each in 48 geographic regions in the United States, plus one for New York, Los Angeles, and Washington, D.C., where one such license had already been granted without an auction. The auctions added more wireless providers throughout the country, greatly increasing competition not only in mobile telephony but also in broadband access.25
Federal policy makers were (and continue to be) most interested in the auctions as a way of raising money, either to reduce the deficit or to contribute toward funding federal programs. Economists who have advocated auctioning off spectrum have long highlighted this advantage of auctions over alternative means of allocating spectrum licenses. But economists have also placed equal, if not more, importance on the efficiency benefits of auctions, which allocate licenses to the highest bidder rather than to the first in line, the one with the best lawyer, or the best political connections. Being the highest bidder concentrates the mind toward making the most profitable use of the spectrum as quickly as possible. Successful bidders who find they cannot do this on their own have the ability, under an auction system, to resell their licenses to those who can make better use of the license. In contrast, those who gain licenses through administrative means are not likely to be as eager, creative, or efficient as those who actually have to pay market value for their use of spectrum.
Mobile telephony, and later smartphones, really took off in the United States after the PCS auctions in the 1990s. With multiple wireless carriers serving customers throughout the country, competition drove down prices and encouraged greater use. This has continued to happen even though the wireless industry has experienced significant consolidation, with the major players buying out local and regional carriers to assemble nationwide networks that permit calls from and to any destination in the country without handing them off to multiple carriers in between. In the process, wireless telephony and broadband have obliterated the once stark distinction between local and long-distance calls and data transmissions, and in the process have undermined the once seemingly impregnable local landline monopolies. Today, cell phones outnumber landline connections; this is even truer abroad, especially in developing countries, where getting a landline connection can take months or years.
Again, technologists and engineers deserve most of the credit for the wireless communications revolution. But their creations would not have been commercialized as rapidly or as efficiently without the wisdom of economists who urged the auction of the electromagnetic spectrum that helped make this revolution possible.
Economists and Price Cap Regulation
While economists were important behind the scenes in facilitating the introduction of more competition in telephony, they were front and center in developing an important innovation in the way all monopoly utilities, including telephone service, are regulated.26
Mindful of the tendency of profit-maximizing monopolies to limit output, which artificially raises prices to consumers, regulators for many decades adopted “rate of return” or “cost of service” regulation to limit prices or rates. Under this approach, regulators assure utilities they can earn a “reasonable” profit on investments in the physical capital required to deliver such services as electricity, water, or telephony, but not monopoly-level profits. Regulators define a “rate base” of total allowed physical investment, multiply it by a rate of return they believe fair, and then add the total permitted profit to the total allowable costs for providing service in a given area to generate target revenue. This figure can be divided by a projection of the total units of service provided—kilowatts of electricity or total number of basic phone lines for local telephony—to arrive at an approved rate or price of service. Alternatively, if regulators don’t want to project future service levels, they can simply limit this year’s rates to the prior year’s costs, including an allowance for reasonable profit.
As briefly noted in the previous section, Leland Johnson and Harvey Averch highlighted an important weakness of this traditional method of limiting prices: It gives utilities an i
ncentive to overinvest or to “gold plate” because the larger the rate base, the greater their profits.27 In addition, although regulatory agencies can second-guess the necessity of some operating costs, as a practical matter, regulated firms are in a better position than their overseers to make these judgments. As a result, regulators are likely to allow the firms they regulate to operate with some inefficiencies included in their allowable rates.
Another drawback to rate-of-return regulation arises if the utility is in another business than the one for which rates are set, such as the equipment manufacturing business of the old AT&T. In these situations, regulators must render some judgment on the allocation of overhead costs that the regulated entity (telephone service) shares with its unregulated affiliate (equipment manufacturing). There are no hard and fast rules about how this should be done. Under rate-of-return regulation, the regulated enterprise has clear incentives to allocate as much cost as it can get away with to the regulated enterprise, which can be recovered through permitted rates. In this way, the regulated monopoly can effectively subsidize the operations of its unregulated affiliate, potentially leveraging monopoly power from the regulated market to the market where the unregulated entity competes.28