Los Defensores Públicos

History of the Telecommunications Industry

The voice telecommunications service industry began in California in 1878, when Western Un- ion opened the first large commercial switched exchange in the nation in San Francisco.238 Such local telephone exchanges ushered in the era of the Public Switched Telephone Network (PSTN), releasing users from the limitation of being able to call other parties on the same wire only.239 The Bell System, the largest telecommunications company in the nation from the beginning, grew over the next several decades to include regional local-service companies, a long-distance company (AT&T) providing toll service, and a manufacturing arm providing equipment. Despite attempts at oversight by the Interstate Commerce Commission beginning in 1910, Bell was ag- gressive in competing with and acquiring many of its competitors.240

By the 1930s, AT&T had a total monopoly on long-distance service and controlled about 80% of local phone service. Surviving independent local exchange carriers (LECs), including GTE and Roseville Telephone in California, were generally located in rural areas and had fewer subscrib- ers. Although the independents were never part of the Bell System, their local networks were in- terconnected with AT&T’s long-distance network.

The landmark Communications Act of 1934 was enacted in response to AT&T’s dominant mar- ket position. Because early telecommunications technology was believed to have economies of scale and scope, monopoly provision of local and long-distance service was thought to be effi- cient.241 Therefore, instead of breaking up AT&T, the act set up regulation to allow AT&T and the LECs to operate as legal monopolies. In return, the regulated firms set rates to further the regulators’ policy goal of universal service.242 This meant that local phone service was relatively inexpensive, and was subsidized by high long-distance rates. Through rate regulation, implicit subsidies also flowed from business subscribers to residential subscribers and from urban sub- scribers to rural subscribers. Regulatory authority was split between the FCC, which set rules for

238 _{This section draws on Shepherd (1993), Brock (1994), Vogelsang and Woroch (1998), Farley (2001a), and Na-}

tional Research Council (2002). A small exchange had already opened in New Haven, Connecticut.

239 _{For a quick reference for the many acronyms and technical terms in the report, see the glossary beginning on}

page 107.

240 _{Acquisitions included Western Union’s telephone business, and its San Francisco exchange, in 1879.} 241 _{Economies of scale imply that per-unit costs for service drop as the quantity of service provided increases.}

Economies of scope imply that it is cheaper for a single firm to offer multiple services (e.g., local and long-distance calling) than for the services to be offered individually by different firms. Whether the AT&T system and the LECs were truly “natural monopolies” characterized by economies of scale and scope in later years has been questioned (Evans and Heckman [1984], and Shin and Ying [1992]).

242 _{For a detailed exposition of the implicit and explicit subsidies to further universal-service goals resulting from}

this rate structure, see FCC Common Carrier Bureau, Preparation for Addressing Universal Service Issues: A Re-

interstate telecommunications traffic, and the state public-utility commissions (PUCs), which oversaw local and other intrastate traffic.243

AT&T and the independents were all treated legally as common carriers. A common carrier of- fers telecommunications transmission service to the public and does not provide or control the information transmitted by the end user. By contrast, cable service providers (which enter the telecommunications story at a later date) are private carriers, because they control both the in- formation content and its transmission.

Recent Changes in the Industry

The recent history of the industry is characterized by technological innovation that forces regula- tors to continually adjust and adapt outmoded forms of regulation. In the 1970s and 1980s, tech- nical innovation by MCI and other competitors in creating alternatives to AT&T’s long-distance network forced the opening of the long-distance market. AT&T’s aggressive response to long- distance competition triggered a federal antitrust case that resulted in a consent decree in 1982 known as the Modified Final Judgment. The Modified Final Judgment required AT&T to divest its local exchange Bell Operating Companies (BOCs), spawning the “Baby Bells” as independ- ent firms. The Bell Operating Companies were required to provide equal access to the local net- work to any long-distance company, to level the playing field between AT&T and its competi- tors.

AT&T and the newly divested Bell Operating Companies were under a requirement of structural separation for the provision of advanced telecommunications services. If these firms wished to offer enhanced telecommunications services such as computer gateway services or voice mail, they were required to form a separate (unregulated) subsidiary. These rules, along with the dives- titure of the Bell Operating Companies by AT&T, erected walls between the monopoly segment of the industry (basic local telephone service) and the more competitive segments (long-distance services and enhanced services).

Deregulation, Competition, and Evolving Market Structure

The Modified Final Judgment set the stage for the eventual deregulation of large parts of the in- dustry. In each case, deregulation was prompted by technological change. Computerized switch- ing based on expansible platforms, interconnection of networks, the digitalization of communica- tions, and optical fiber all reduced communications costs. Decreasing costs have diminished the significance of economies of scale and scope, compared to the original Bell System. With the weakening of the economic argument for monopolization of the industry came increasing pres- sure from competitors to allow entry into ever more markets. Here we consider a few of the ma- jor markets opened to competition in the last two decades.

243 _{A telecommunications line is regulated in the federal jurisdiction if at least 10% of its traffic is interstate, based}

on the final destination of the call (even if the termination of the call requires carriage over other lines and net- works). Thus access lines for long-distance service, even though physically residing within a single state, are con- sidered interstate for regulatory purposes because they connect to the interstate long-distance network.

Long-Distance Services

From the Modified Final Judgment through the 1990s, the long-distance market transformed from near monopoly to a much more competitive market. By 1995, AT&T’s market share had eroded enough that the FCC dropped price regulation of its long-distance services completely. For the first time, prices in the long-distance market were disciplined only by market forces and not by direct price regulation. The resulting market structure by 1999 was an oligopoly with a competitive fringe: AT&T’s market share had declined to about 40% of toll revenues reported by interexchange carriers (IXCs), MCI WorldCom’s share was 25%, Sprint’s was 10%, and the re- maining quarter of the market was divided among more than 700 other IXCs.244

When the FCC deregulated AT&T’s long-distance rates, most state PUCs followed suit. In 1995, the California Public Utilities Code was amended.245 This was done to exempt telephone compa- nies lacking “significant market power” from the requirement to file tariffs.246 In January 1997, the California Public Utilities Commission (CPUC) specifically exempted non-dominant interex- change carriers (mainly carriers other than the local toll arms of the LECs) from filing tariffs. Later in the year, the CPUC switched AT&T’s regulatory status from dominant to non-dominant, which also released the firm from remaining price regulation.247 By the time of the ruling,

AT&T’s share had fallen in the California intrastate interexchange market to 55%, down from 95% in 1984.248

The largest potential entrants in the long-distance market are the Bell Operating Companies. Since the Modified Final Judgment, Bell Operating Companies have been permitted to offer long-distance only within a regional calling area (LATA).249 It is important to recognize that there is no technological reason preventing Bell Operating Companies from providing inter- LATA interexchange services; it is merely regulatory restrictions on the Bell Operating Compa- nies’ lines of business, first from the Modified Final Judgment and more recently from The Tele- communications Act of 1996 (TA96). In fact, LECs are likely to be highly competitive with ex- isting IXCs once they are allowed to enter the market. Section 271 of TA96, and the FCC’s sub- sequent interpretation of it, allows the Bell Operating Companies to enter into the long-distance market only after their local markets are sufficiently open to competition. In 1998, the California BOC, Pacific Bell, filed with the CPUC for permission to offer long-distance service. As of July 2002, the motion had not been granted.

244 _{Industry Analysis Division, Common Carrier Bureau, FCC, January 2001, Statistics of the Long-distance Tele-} communications Industry. For evidence that the three largest firms retained market power at least through 1997, see

MacAvoy (1998).

245 _{California Public Utilities Code §495.7 (created by AB 828, approved by the governor October 12, 1995).} 246 _{A tariff is a public list of prices, terms, and conditions for the service offerings of a carrier, filed with the CPUC.} 247 _{AT&T had formerly been under rate of return regulation. California Public Utilities Commission, Decision 97-}

08-060, August 1, 1997.

248 _{Ibid. AT&T still files formal tariffs in California (one of only four states in which it still does so). However,}

AT&T’s rates are disciplined by the market and not by overt price regulation in California, as evidenced by AT&T’s nationwide uniformity in its calling-plan rates.

249 _{Local access and transport areas (LATAs) were created by the Modified Final Judgment and define the geo-}

graphic area over which the LEC may provide toll calls. The area may be smaller than that covered by a long- distance area code. Even though an LEC’s territory may cover many LATAs (PacBell’s in California includes 10 LATAs), the LEC may not provide calls that cross LATA boundaries; such interLATA traffic must be carried by IXCs.

Local Services

The Modified Final Judgment left local telecommunications in the hands of the Bell Operating Companies and the independent LECs, each with a monopoly in its service territory. Erosion of the LECs’ market share first began in the access services market. A long-distance call requires a connection from the customer’s premises to the IXC’s network point of presence (see Figure E- 1). This part of the call is called “access,” and is typically provided by the LEC. The regulated rate structure of the LECs had prices for access that were higher than cost in urban locations. A new type of telecommunications firm, called a competitive access provider (CAP), sprang up in the second half of the 1980s to exploit the pricing inflexibility of the regulated LECs. Competi- tive access providers offered businesses private-line connections to the long-distance network or to other nearby locations, such as a direct connection between a firm’s data-processing center and its executive offices down the street. Competitive access providers were able to underprice the LECs on these so-called special-access lines.250 By 1990 in California, competitive access providers included Bay Area Teleport in San Francisco and Metropolitan Fiber Services (MFS) and Teleport Communications Group (TCG) in San Francisco and Los Angeles.

Between 1989 and 1992, New York and Illinois became the first states to require the LECs to accept requests from CAPs to interconnect their networks. Interconnection meant that now the competitive access providers’ customers could terminate calls to customers of the LEC, as in Figure E-2. In other words, for the first time true competition in local telephony was possible, and competitive access providers were becoming full-fledged competitive local exchange carri- ers (CLECs). The FCC followed in the first half of the 1990s with rules requiring interconnection of CAPs’ and LECs’ networks in the federal jurisdiction. Before the passage of the TA96, some states still did not require or allow local network interconnection.

250 _{Because CAPs bypassed the LECs network altogether, the CAPs’ implementation of access services was known}

as bypass.

Figure A-1

TA96 swept away all state and local regulations restricting entry into local telecommunications markets. It contains several other provisions to encourage local competition by CLECs, includ- ing:

Incumbent LECs must allow other carriers to interconnect their networks at all feasible points. Competitors can rent space in the incumbents’ central offices (COs) for intercon- nection, known as collocation. CLECs must be given access to physical and virtual infra-

structure such as rights of way, ducts, poles, telephone numbers, databases, and directo- ries.

Incumbent LECs must offer subscribers number portability, which allows subscribers to take their telephone numbers with them when they change carriers.

CLECs are to have dialing parity, which allows their subscribers to dial without special- access codes or delays.

Incumbent LECs must allow CLECs to resell all of the ILECs services, with mandated wholesale discounts.

Incumbent LECs must offer CLECs unbundled network elements (UNEs) for lease, which allow CLECs to choose only those elements needed to complete their networks. Unbundled network elements allow CLECs to buy fewer elements as their own networks become more complete. Unbundled network elements must be priced at economic cost. Thus, TA96 enables a CLEC to enter the local market in three ways: 1) by reselling the incum- bent LEC’s services, 2) through purchase of unbundled network elements from the incumbent LEC to complement a CLEC’s infrastructure, and 3) full facilities-based entry with a complete network that is interconnected to the incumbent LEC’s network. Six years after TA96, the in- cumbent local telephone companies still provide 94% of residential telephone lines and 80% of business lines nationally.

Figure A-2

In California, the CPUC issued rules for local competition and mandated wholesale discounts (17% for Pacific Bell, 12% for GTE California) in 1996.251 All but a few local services were re- classified from monopoly to more competitive services. Reclassification allowed the LECs more pricing flexibility and the option of going “off tariff” in customer-specific contracts, which were not previously allowed for monopoly services. In California in 1999, incumbent LECs garnered $6.9 billion in end-user revenue, nine times as much as CLECs did.252

Information Services

For purposes of federal regulatory classification, telecommunications services are divided into basic and enhanced services. Basic service, also known as POTS, refers to standard voice trans- mission offerings.253 Enhanced services, more recently termed “information services,” are de- fined in TA96 as services “generating, acquiring, storing, transforming, processing, retrieving, utilizing, or making available information via telecommunications.”254 As mentioned previously, after the Modified Final Judgment, AT&T and the Bell Operating Companies were at first re- quired to offer information services only through separate subsidiaries. Beginning in 1986, the FCC allowed the regulated carriers to offer information services on an integrated basis, if they made the underlying network functionality available to competitors.255 The first such services were protocol conversion services, which were followed by voice mail and fax services, email services, and Internet-access services.

The FCC ruled in the 1970s that enhanced service providers are not subject to federal regulation under the Communications Act, even though they use the telephone network. In California, in- formation services are considered competitive and are not regulated by the CPUC, even if of- fered by otherwise regulated firms. In most of this report we do not focus on information ser- vices, except where they intersect directly with basic services. For example, Internet-access ser- vice is an information service that enables Internet telephony, a substitute for basic telephone service.

Technological Change and Convergence

The rapid pace of technological innovation has left the local and long-distance markets vulner- able to entry from firms of many different types. The move from analog voice communication over copper wire to digital communication over many modes of transport (copper, fiber optics, wireless spectrum) opens possibilities for many non-traditional telecommunications firms. This

251 _{CPUC Decision 96-03-020, March 13, 1996.}

252 _{Figure includes intrastate and interstate end-user revenue (which apparently includes both resale and facilities-}

based revenue) from Tables 3 and 4, FCC, Industry Analysis Division, Common Carrier Bureau, State-by-State

Telephone Revenues and Universal Service Data, April 2001.

253 _{POTS is an industry acronym for plain old telephone service, and distinct from PANS (pretty amazing [variously}

“awesome”] new stuff [variously “service”]) services.

254 _{Communications Act §3(20), 47 U.S.C. §153(20). Information services were called “enhanced services” (with a}

similar definition; see 47 C.F.R. 64.702(a)) and were distinguished from basic services in the FCC’s Computer In-

quiries, beginning in the 1970s.

255 _{See Prieger (2002) for a review of this regulatory regime and the effect it had on the introduction of information}

section recounts some of the more prominent forms of competition that the incumbent telecom- munications voice-service firms are likely to face in the near future.256

Figure 1 in the opening section, Introduction, depicts a stylized view of the call path through the communication networks involved in each technology described here. Traditional wired teleph- ony is depicted in panel A of Figure 1: a telephone call passes from an end user to the LEC’s central office over the copper local loop. If the call is an interLATA long-distance call, the LEC routes it to the end user’s pre-subscribed long-distance company’s point of presence. The inter- exchange carrier then routes the call to its point of presence nearest the destination, where the call then passes to the destination LEC’s central office and the called party. Figure 1 shows only the “first half” of each type of call path, given that any one kind of call can be terminated by any other kind of call. Appendix B contains more information on various types of telecommunica- tions services and firms.

Competitive Local Exchange Carriers: Facilities-Based and Resellers

As recounted before, competition in local service first began with competitive access providers providing businesses with access services. By now most competitive access providers have trans- formed into full-service CLECs and offer both residential and business local and toll service. While many CLECs own no facilities and exist solely as resellers, many of the older CLECs provide their own switching and transport. Such CLECs are called “facilities-based.” These CLECs usually still purchase local loops (the “last mile” connection to individual subscribers) as unbundled network elements from the incumbent LEC, although many have deployed high-speed networks directly connecting to office buildings in dense urban business districts for business traffic. Panel B of Figure 1 shows a call path for a facilities-based CLEC leasing space in the in- cumbent LEC’s central office.