Consumers on Hold

The future could be today if the Baby Bells were allowed to grow up

In the not-so-distant future, nearly every household with telephone service could reach out and touch, and be touched by, thousands of new consumer services through an inexpensive screen and keyboard plugged right into the phone outlet. Unfortunately, U.S. antitrust laws stand in the way.

The federal court supervising the 1984 breakup of AT&T effectively banned the local phone companies from providing a variety of services made possible by advances in computer and telecommunications technology:

• Consumers who now fumble through thousand-page telephone books could view the yellow pages on-screen and find business listings cross-indexed by dozens of different criteria. New businesses would not have to wait for new phone books to be published before they could be listed. Big-city residents would be spared the hassle of dealing with multivolume phone directories.

• Deaf people could use a screen and keyboard to carry on private phone conversations.

• Elderly people, shut-ins, two-career families, and others with limited mobility or time could compare prices for groceries and other goods, place orders, and have the goods delivered without leaving home.

• Both businesses and labor unions could carry on detailed and regular communications with employees who choose to work at home.

• Families buying homes could shop for the best mortgage rates and apply instantly without relying on a real estate agent.

• Students, scientists, and other researchers could use an electronic screen to read books located in libraries thousands of miles away.

Many of these services, such as electronic directories and shopping, are already available in other countries. Some are also available in the United States—to anyone who wants to invest a few thousand dollars or so in a personal computer, modem, and software, then spend aggravating hours figuring out how to use all three. The National Telecommunications and Information Administration reports that approximately 1 million individuals and businesses subscribed to such services in 1987. But the average person who cannot afford a personal computer has little hope of obtaining these services unless Congress or the courts lift restrictions that prevent local phone companies from getting into this business.

Companies currently offering "videotex" services (information services involving telephone lines and video screens) include Lockheed, Mead, IBM, Sears, J.C. Penney, Dow Jones, and several major airlines. Many videotex customers are large businesses, which have little trouble buying computers and other necessary equipment. Households that subscribe have a median annual income of $50,000, according to the Videotex Industry Association.

For most Americans, videotex remains only a dream, because District Court Judge Harold H. Greene, in his continuing control of AT&T's breakup, is stymying development of a market in information services.

The 1984 breakup of AT&T radically restructured the nation's telecommunications industry. To settle an antitrust suit initiated by the federal government 10 years earlier, the monolithic Bell System was separated into AT&T and 22 local telephone companies, most of which were organized into seven regional Bell operating companies. Each of the seven is a major corporation in its own right, with revenues ranging last year from $8.5 billion to $13.7 billion. The settlement opened long-distance phone service to competition, but the Federal Communications Commission (FCC) continued to regulate long-distance phone rates. AT&T also received permission to enter many unregulated businesses, such as computer sales.

The 22 local phone companies, often called the "Baby Bells," were supposed to concentrate on offering local phone service, which is regulated by the states. To this day, most states largely prohibit competition with these established companies. As Jack High, an antitrust economist and director of George Mason University's Center for the Study of Market Processes, notes: "The government was concerned with monopoly, but the real source of any monopoly power that AT&T had was its local phone monopolies. Instead of pressing the states to promote competition locally, the federal government broke up AT&T."

Also as part of the breakup agreement, the Baby Bells were forbidden from manufacturing telephone equipment, offering long-distance service, or providing information services such as videotex. In 1987 when it came time to review these three-year restrictions in the context of current circumstances in the industry, both the Justice Department and the FCC urged the court to free the Baby Bells to make equipment and provide information services. They based their recommendations in part on a massive, 3½-pound report, The Geodesic Network, compiled in 1987 by engineer and lawyer Peter Huber for the Justice Department.

Judge Greene refused to go that far, but he did permit the Baby Bells to develop "gateways," which let callers locate and use a variety of information services by dialing a single phone number. As part of a one-year trial program in Pennsylvania, for example, customers of Bell Atlantic can call one number and then select on their computer screens from a list of companies offering airline flight schedules, stock quotations, news, publications, legislative updates, and other information. Even though subscribers may use services offered by several different companies, they will generally receive only one monthly bill. The catch is that they must have personal computers and modems.

To create a mass market for information services, the number of potential consumers must be expanded beyond those who now own computers. Someone must widely distribute simple, low-cost terminals—video screens and keyboards—that plug into the phone lines. In other countries, this someone is the government. In France, which has the most widespread consumer videotex system, the government has given away 3.7 million terminals. Thirteen percent of French households are on-line.

The idea of the U.S. government spending millions of taxpayer dollars on a videotex-in-every-home program, which basically would help generate business for the telephone companies, is not politically feasible. Fortunately, neither is it necessary. For the same reason that cellular telephone carriers have been reducing the costs of telephones, the Baby Bells would be eager to provide videotex hardware if they could offer their own information services. In addition to the profits they would get from selling these services, they would save the huge cost of printing telephone books. Indeed, the Baby Bells are lobbying in Washington these days not for subsidies but simply for permission to compete.

Judge Greene continues to bar the Baby Bells from offering information services because he fears that they would engage in three types of anticompetitive behavior: predatory pricing, cross-subsidization, and discrimination against competitors. These are all more theory than reality.

"Predatory pricing" is antitrust lingo for a company selling its product below cost until it drives its competitors out of business, and then recouping its losses by charging monopoly prices. Under this theory, for example, the Baby Bells might sell stock quotations below cost and force Dow Jones's stock-quotation service to go out of business. Then the Baby Bells could jack up their own prices to make up for earlier losses—and then some.

There are a lot of problems with this theory. The Baby Bells would have to be willing to take large losses on the gamble that this predatory strategy would succeed, during which time consumers enjoy fabulously low prices. And even if they could drive out Dow Jones, they would have to figure out how to keep it and other competitors from reentering a profitable market.

It's no wonder that in more than two decades of economic research in a wide variety of industries, predatory pricing has been found highly unlikely because it is generally unprofitable. In a 1982 University of Chicago Law Review survey of economic studies of alleged cases, including the famous Standard Oil case of 1911, Judge Frank Easterbrook concluded that "the antitrust offense of predation should be forgotten." Similarly, when asked in 1986 if the Federal Trade Commission should issue an annual report on predatory pricing, one commissioner replied the FTC might just as well issue an annual report on unicorn sighting.

At first glance, "cross-subsidization" sounds similar to predatory pricing. Both involve selling below cost. Under the theory of cross-subsidization, however, the Baby Bells would be content to sell stock quotations at a loss forever and would make up their losses by charging higher prices for ordinary local phone service.

Why would the Baby Bells ever want to cross-subsidize? It has to do with the way local phone rates are regulated. In most cases, governments limit phone companies' return on their investment instead of the prices they charge.

Economists have long recognized that a company thus regulated can sometimes make a greater profit by artificially inflating the amount of capital it uses—the more capital the company employs, the larger will be the total revenue generated by a given rate of return. One way to boost the capital base is to buy equipment to use in unregulated businesses, such as information services, while claiming to use it in providing local telephone service. Local telephone customers then end up subsidizing information services, and the Baby Bells are permitted by misled regulators to skim greater profits.

The FCC claims that with detailed standards and requirements, including cross-checks by independent auditors, it can prevent such fraudulent accounting. But even this intense scrutiny would not be needed if state regulators would change the way they regulate the Baby Bells. If cross-subsidization is the worry, regulators could put caps on telephone rates, rather than picking some acceptable percentage of profit. This would give the companies an incentive to cut costs to increase their return, rather than to pad their expenses.

Price caps are used extensively in England, and the FCC recently switched from rate-of-return regulation to price caps for AT&T's long-distance service. Already 18 states have initiated price caps or other flexible-rate experiments for long-distance service within their borders. Critics of this approach believe that any benefits from lower costs will never be passed along to consumers. Neither regulatory scheme—price caps or rate-of-return—is perfect, but price caps could remove the threat of cross-subsidization.

Like cross-subsidization, the third potential problem, discrimination, stems directly from the Baby Bells' local monopolies. Information-service providers must use the local phone lines to reach most households and many businesses. But if the Baby Bells are the only ones in the local telephone business, and are also allowed to enter the information business, they may use their control over local lines to keep competing information providers from reaching customers.

Here too the FCC believes that it can solve the problem. Through an elaborate set of rules, it prevents the Baby Bells from using muscle tactics: denying competitors access to the local phone lines, charging them a higher price than they charge themselves, or giving competitors inferior service.

Regulation of the Baby Bells would perhaps become more difficult if they were allowed to enter the information business, but certainly not impossible. Allowing the Baby Bells to develop this market, accompanied by regulation, is surely better for consumers than a blanket prohibition.

The problem with regulation, of course, is that in an imperfect world it can always be too much or too little. Fortunately, technological developments may one day make many local telephone monopolies—and thus the need for regulation—obsolete. Peter Huber's 1987 report for the Justice Department points clearly in that direction.

To see how, it's important to realize that in the old days of integrated AT&T, most callers reached out and touched Ma Bell the minute they grabbed the phone. Local calls were routed through local switchboards operated by AT&T-owned local phone companies. Even a call transferred by an employee on one floor of an office building to a coworker on another floor would be routed through AT&T equipment. Long-distance calls went through the local AT&T-owned switchboard to AT&T's long-distance division, which sent them to another AT&T-owned local switchboard in the destination city.

Nowadays, however, many business calls pass through "private branch exchanges." Businesses have established their own phone networks to transfer calls among offices, different buildings, and even groups of buildings. In Baby Bell regions, the number of phone lines served by private branch exchanges has more than doubled since 1982. More business phone lines are served by private branch exchanges than by the conventional local phone companies (though most calls from one private exchange to another are still handled by the local phone company).

Other technologies are also carving out small but growing markets. Although not yet an economical substitute for conventional wire transmission, cellular phone systems have doubled in size since 1982. Microwave, fiber optic, and satellite systems capable of competing with the Baby Bells are also expanding.

Callers on these alternative networks still must use the Baby Bells for local calls to telephones not connected to the same network. But for long-distance calls, they can bypass the local phone company entirely. Private branch exchanges connected directly with AT&T, for example, now account for as many phone lines as any one of the seven Baby Bells. In short, the monopolistic part of the nation's telephone network is shrinking to a collection of local telephone loops, and even callers in many of these loops have the alternative of building their own local network.

In the future the Baby Bells may also have to deal with a giant intruding on their turf: cable television companies. Some day regulators may realize that two companies engaged in the business of running wires into people's houses might also be able to compete with one another in offering both telephone and television service.

Already, a political battle over this issue is simmering. FCC regulations, along with narrower legislation passed in 1984, combine with the AT&T breakup agreement to keep telephone companies out of the cable television business. But the Baby Bells are preparing to fight the $14-billion cable industry for a piece of this market. They have the support of cable programming producers such as the Motion Picture Association of America. Likewise, cable companies are well-suited to offering phone service, especially since the fiber-optic cable that may help transmit a new generation of "high definition" television signals would give cable companies the ability to transmit voice and data as well.

These developments suggest that the most economical telecommunications system of the future will consist of a variety of competitors in both local and long-distance service. Telecommunications companies capable of adapting to this new environment will grow and prosper. Those artificially restricted to offering only certain types of services will lose markets to more-nimble competitors. Huber suggests that if the Baby Bells are prohibited from entering new markets, "it remains quite possible that [they] will become the U.S. Post Office of electronic telecommunications, absolutely essential to many, with steady or even growing traffic, but moribund nonetheless." No doubt such a realization explains why the Baby Bells, whose positive financial performance after the breakup surprised many investment analysts, are nevertheless scrambling to offer more than local phone service.

While the Baby Bells, federal agencies, and consumer groups appeal Judge Greene's 1987 decision, Congress seems ready to take matters into its own hands. Last year, Rep. John Dingell (D–Mich.), powerful chairman of the House Energy and Commerce Committee, introduced a concurrent resolution endorsing the idea of allowing the Baby Bells to offer information services and manufacture telephone equipment. It had 205 cosponsors. In April of this year, Reps. Al Swift (D–Wash.) and Tom Tauke (R–Iowa) introduced legislation to remove the restrictions.

The regulatory reform movement faces a tougher challenge in the Senate. Feuds with the FCC over the Fairness Doctrine and other issues unrelated to the Baby Bells have prompted Sen. Ernest Hollings (D–S.C.), chairman of the Senate Commerce Committee, to view most proposed reforms suspiciously. Nevertheless, Sens. John Breaux (D–La.) and Ted Stevens (R–Alaska) have pushed Congress to take up the issue, introducing a concurrent resolution similar to Dingell's last year, and Hollings may be mollified somewhat by the impending resignation of his chief nemesis at the FCC, Chairman Dennis Patrick.

No doubt many legislators are prompted to action by the immense consumer benefits promised by a less-regulated, high-tech telecommunications industry. Rep. Swift commented last year: "The question we must ask ourselves is whether existing government policy provides adequate incentives to U.S. industry to invest in this nation's economic and technological future. The restrictions imposed in the aftermath of the AT&T divestiture provide a negative answer to this question. We believe we can do better!"

As long as legislators fail to act, they must realize that federal courts and an independent regulatory agency, rather than Congress, are shaping the course of telecommunications policy. Congressional fear of losing control could well be the strongest force in making a wealth of information services available to every consumer.

Jerome Ellig is director of public policy at Citizens for a Sound Economy Foundation. Phillip Mink, Nancy Oliver, and Michele Isele of the foundation's Legal and Regulatory Reform Project contributed to this article.