TCS Daily

Court Ruling Slams Consumers

By R. Glenn Hubbard - March 8, 2004 12:00 AM

The ruling issued this past Tuesday by the Court of Appeals for the District of Columbia Circuit essentially lifts the 1996 Telecom Act's requirement that the major Bell Companies lease key unbundled elements from their local networks to competitive carriers. This sounds like a technical issue not worth the time of day, but the decision has enormous impact. If it holds, well more than 10 percent of the U.S. population will see an almost immediate enormous increase in their phone bills. The rest will fail to benefit from future competition in innovative telecommunications services.

Disagreements over law are commonly settled by Congress and regulatory commissions in their own good time - while public and commercial lives go on without too much notice. But, this is not the case here. Over the seven years since the passage of the Act, competitive carriers and customers have relied on repeated determinations by federal and state regulatory agencies, multiple federal district courts and the U.S. Supreme Court that offerings of competitive telephone service employing leased unbundled elements are both legal and desirable. As a result, more than 19 million customer lines have been switched from the incumbent Bell carriers to competitive carriers. Capitalists have invested their money in business plans that rely upon the successful enforcement of the law. This ruling pulls the rug out from under these firms and their customers.

The competition of recent years has benefited consumers. The presence of competitive offerings based on unbundled elements has caused consumers to be offered new, innovative services (such as broadband) and to enjoy price declines typically between 25 and 30 percent. And (just as basic economics would have predicted) this competition has caused investment in the telecommunications and information technology industries to soar. Furthermore, this more competitive market structure has been achieved while continuing to provide full economic compensation to the incumbents for use of their network elements, denying them only the supernormal returns they used to acquire by gouging captive consumers.

Basic economics teaches us that all firms want to make the largest profit possible. If you are a firm in a competitive market, the only way you can do this is by offering customers a superior product that justifies a higher price, or to outsmart the competition and produce a similar product at a lower price. A competitive firm cannot improve its profits simply by raising its price. That would only result in customers shifting their purchases to other suppliers. While a monopoly firm can also use either of the above two strategies to improve its profit, it has a third strategy: Produce less and charge more. Since producing less and charging more is "easy," and improving your product or your productive efficiency is "hard," the Bell monopolies have repeatedly chosen the easy path that is bad for consumers.

While the above economic paradigm is simple, it explains nearly all that has gone on in telecom since the passage of the Act in 1996. The Bells' competitors (the CLECs or competitive local exchange carriers) have sought to expand local telecom markets. They have innovated by being the first major providers of DSL, VOIP, and flat-rate calling packages. They have sought to keep their costs low and their output high by investing in modern efficient equipment, seeking cost benefits from scale through aggressively low pricing, and, when the natural monopoly characteristics of a vital network component make their self-supply uneconomic, trying to lease use of necessary components from the ILEC (whose greater scale causes the cost of its supply of the element to be less than for the CLEC).

The ILECs, on the other hand, because they have a base that consists of a wealth of existing products, productive capacity and customers, have sought to inhibit output growth - both by themselves and by competitors. Inhibiting their own output is simple, they don't reduce prices and they don't invest in increased productive capacity. Most importantly, they have continued to seek ways to stunt the ability of CLECs to bring greater product to the market or to establish new lower price points. The most effective ways are to deny access to critical elements of the Bell networks.

The D.C. Circuit's USTA opinion is a model of poor economic analysis. The most disturbing part of the court's finding is the link between their ruling and incentives to invest. This is the most anti-competitive portion of the D.C. Circuit decision. Again, economics teaches that everything else equal, monopolists avoid investment because it tends to raise output and depress prices; and that competitive returns promote the optimal level of investment. The economic analysis provided by the Bells to oppose this simple argument just does not survive close inspection.

Economics also teaches that a competitive firm will not invest if it is cost-disadvantaged relative to its incumbent rival. And recent history confirms this intuition. Prior to 1996, Bell investment was moribund. These firms faced no competitive pressure, they introduced no innovative products, and they already had a sunk network in place that offered them productive capacity adequate to meet demand at the prevailing (high) monopoly price. After 1996, CLEC entry and investment boomed, $55 billion through 2000. CLECs introduced new services (DSL), new calling plans, and provided bundles that integrated multiple telecom needs. As a result, demand exploded and bundled service pricing declined.

The ILECs responded as well. Despite having sat for half a decade on their own DSL technology, they introduced it. They ramped up their construction programs and added new capacity and features to the network - and one important source of demand for this capacity came from competitors who paid wholesale rates to get on the Bell networks, and increased the Bell profits for operating new technologies.

This growth in telecom capacity and output was symbiotic with the national economy - both contributed to the amazing health of the other. For the ILEC, the only problem was not that this new situation was unprofitable - only that it was not as profitable as pure monopoly.

The D.C. Circuit's actions will bring all of this to a halt.

CLECs currently serve over 19 million customer lines over UNEs. These are predominantly residence and small business lines. In addition, CLECs serve about 7 to 8 million more lines over their own facilities. These are predominantly large business lines. Price and service have been the reason why 19 million lines have shifted to competitive carriers. Indeed, competitive pressure has evoked price declines of 25 to 30 percent or more. Families have taken these savings and plowed them into still further telecom purchases (for example, broadband, ISP service, home networks, etc.) as well as other more general consumption. This has been a major driver of further growth within the sector and across the economy generally.

The court's misreading of economic analysis will have an immediate chilling effect on competition. Already, we have seen SBC suggest that in 90 days time, it expects this court decision will enable it to raise the cost of competitive phone service for residential and business customers by about $10 per line per month. We can also expect these unbundled element price rises to result in a number of competitive carrier bankruptcies, harming consumers who are forced on short or no notice to secure alternative carriers.

These events add an economic cloud this year, but there is a way out. The good news is that these untoward and untimely shocks can easily be avoided. The D.C. Circuit stands virtually alone in its view that most competitive provision of local phone service through the use of unbundled elements is unlawful. In such a circumstance, the best solution appears to be an immediate appeal for certiorari to the Supreme Court. Not only will this ensure an appropriately measured final decision on the legal and public policy merits of this issue, but it will also end the costly uncertainty that the D.C. Circuit's decisions on unbundled element competition has injected into the overall telecommunications and information technology industries.

While the D.C. Circuit is entitled to its view that unbundled element-based competition is largely unlawful, the standard economic view is that such competition is certainly desirable and enhances greatly the performance of our economy.

Mr. Hubbard, the Russell L. Carson Professor of Economics and Finance at Columbia University was Chairman of the Council of Economic Advisers under President George W. Bush from 2001-2003.


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