Economics of Networks

The Telecommunications Act of 1996 and its Impact*

by Nicholas Economides**

September 1998


This paper analyzes the effects on the implementation of the Telecommunications Act of 1996 ("Act") on US telecommunications markets and is based on my forthcoming book with the same title. The Act is a milestone in the history of telecommunications in the United States. Coming 12 years after the breakup of AT&T, the Act attempts to move all telecommunications markets toward competition. The Act envisions competition in all telecommunications markets, both in the markets for the various elements that comprise the telecommunications network, as well as for the final services the network creates. Building on the experience of the long distance market, which was transformed from a monopoly to an effectively competitive market over the last 12 years, the Act attempts to promote competition in the hitherto monopolized local exchange markets. The Act recognizes the telecommunications network as a network of interconnected networks. Telecommunications providers are required to interconnect with entrants at any feasible point the entrant wishes. Most importantly, the Act requires that incumbent local exchange carriers ("ILECs") (i) lease parts of their network (unbundled network elements) to competitors "at cost"; (ii) provide at a wholesale discount to competitors any service the ILEC provides; and (iii) charge reciprocal rates in termination of calls to their network and to networks of local competitors. Moreover, the Act requires that ILECs that came out of the Bell System meet a number of requirements, including a public interest test, before they may enter into the long distance market. Thus, the Act provides some safeguards against the export of ILEC monopoly power to other parts of the network. Numerous legal challenges to the Act and its implementation have been raised by the ILECs resulting in very slow implementation of the Act, and, in many cases, in no substantial implementation of the provisions of the Act. Thus, more than two years after the passage of the Act, there is very little entry and competition in local exchange markets. In response to the apparent failure of the implementation Act, there has been a wave of mergers in the US telecommunications industry.

Forthcoming, Japan and the World Economy

Key Words: telecommunications, regulation, competition

JEL Classification: L1, D4

* Presented at the Annual Telecommunications Policy Conference, Tokyo, Japan, December 4, 1997. I thank Hajime Hori, Bob Kargoll, Steve Levinson, and two anonymous referees for helpful comments.

** Stern School of Business, New York, NY 10012. Tel. (212) 998-0864, fax (212) 995-4218. E-mail:, www:

The Telecommunications Act of 1996 and its Impact

1. Introduction

The telecommunications sector has witnessed dramatic reductions in costs in (i) transmission, using fiberoptic technology; (ii) switching and information processing because of reductions of costs of integrated circuits and computers. Cost reductions have made feasible many data- and transmission-intensive services.

Cost reductions usually allow for entry of more competitors and intensification of competition. However, in telecommunications, consumers have not reaped the full benefits of cost reductions and intensification of competition because of an antiquated regulatory framework that, ironically, was created to protect consumers from monopolistic abuses.

The telecommunications sector has witnessed progressive deregulation. The AT&T breakup (Modification of Final Judgement, "MFJ") in 1984 resulted in competition in manufacturing, long distance, 1 and information services, while it kept the regime of regulated monopoly in local telephony.

The direct effect of the breakup of AT&T was competition in long distance. AT&Tís share in long distance is presently at about 50%. At the same time, unexpectedly, local telephone companies (Local Exchange Companies, "LECs") have realized significant profits.

In parallel, wireless telephony grew to great success. The "world wide web" emerged as a ubiquitous network "living" on top of the telephone network. Cable television achieved high penetration. New (and cheaper) wireless services (Personal Communications Services "PCS") and direct satellite broadcast are reaching the market.

2. Goals of the Act

With this background, President Clinton signed the Telecommunications Act of 1996 ("Act" or "1996 Act") into law in February 1996. This was the first major reform since the original 1934 Telecommunications Act. The Telecommunications Act of 1996 attempts a major restructuring of the US telecommunications sector.

The 1996 Act crystallized changes that had become necessary because of technological progress. Rapid technological change has always been the original cause of regulatory change. The radical transformation of the regulatory environment and market conditions that is presently taking place as a result of the 1996 Act is no exception.

The Act will be judged favorably to the extent that it allows and facilitates the acquisition by consumers of the benefits of technological advances. Such a function requires the promotion of competition in all markets. This does not mean immediate and complete deregulation. Consumers must be protected from monopolistic abuses in some markets as long as such abuses are feasible under the current market structure. Moreover, the regulatory framework must safeguard against firms leveraging their monopoly power in other markets.

In passing the Telecommunications Act of 1996 ("1996 Act") Congress took radical steps to restructure U.S. telecommunications markets. These steps may result in very significant benefits to consumers of telecommunications services, telecommunications carriers, and telecommunications equipment manufacturers. But the degree of success of the 1996 Act depends crucially on its implementation through decisions of the Federal Communication Commission and State Public Utility Commissions as well as the outcomes of the various court challenges that these decisions, and the Act itself, face.

The 1996 Act envisions a network of interconnected networks that are composed of complementary components and generally provide both competing and complementary services. The 1996 Act uses both structural and behavioral instruments to accomplish its goals. The Act attempts to reduce regulatory barriers to entry and competition. It outlaws artificial barriers to entry in local exchange markets, in its attempt to accomplish the maximum possible competition. Moreover, it mandates interconnection of telecommunications networks, unbundling, non-discrimination, and cost-based pricing of leased parts of the network, so that competitors can enter easily and compete component by component as well as service by service.

The 1996 Act imposes conditions to ensure that de facto monopoly power is not exported to vertically-related (complementary) markets. Thus, the Act requires that competition be established in local markets before the incumbent local exchange carriers are allowed in long distance service.

The Act preserves subsidized local service to achieve "Universal Service," that is, the provision of basic local service to the widest possible number of customers. However, the Act imposes the requirement that subsidization is transparent and that subsidies are raised in a competitively neutral manner. Thus, the Act leads the way to the elimination of subsidization of Universal Service through the traditional method of high access charges. 2

A potential drawback of the Act is that it does not provide for penalties for non-compliance. It rather relies on the firmsí own incentives to drive them to choose according to what the Act expects. In this respect, the Act may have underestimated the ability of incumbents to stall the implementation process of the Act. Moreover, the Act definitely overestimated the importance of ILECsí long distance entry as an incentive for ILECs to open their local markets to competition. In the last two years, without exception, the ILECs chose to forego long distance entry and rather continue to receive local service monopoly profits.

3. History

Telecommunications has traditionally been a regulated sector of the US economy. Regulation was imposed in the early part of this century and remains until today in various parts of the sector. 3 The main idea behind regulation was that it was necessary because the market for telecommunications services was a natural monopoly, and therefore a second competitor would not survive. Regulation was imposed to protect consumers from monopolistic abuses.

As early as 1900, it was clear that all telecommunications markets were not natural monopolies, as evidenced from the existence of more than one competing firms in many regional markets, prior to the absorption of most of them in the Bell System. 4 Over time, it became clear that some markets were not natural monopolies any more, and that it was better to allow competition in those markets while keeping the rest regulated.

The market for telecommunication services and for telecommunications equipment went through various stages of competitiveness since the invention of the telephone by Alexander Graham Bell. After a period of expansion and consolidation, by the 1920, AT&T had an overwhelming majority of telephony exchanges and submitted to State regulation. Federal regulation was instituted by the 1934 Telecommunication Act which established the Federal Communications Commission.

Regulation of the U.S. telecommunications market was marked by two important antitrust lawsuits that the U.S. Department of Justice brought against AT&T. In the first one, United States v. Western Electric, filed in 1949, the U.S. Department of Justice ("DOJ") claimed that the Bell Operating Companies practiced illegal exclusion by buying only from Western Electric, a part of the Bell System. The government sought a divestiture of Western Electric. The case was settled in 1956 with AT&T agreeing not to enter the computer market, but retaining ownership of Western Electric.

The second major antitrust suit, United States v. AT&T, was started in 1974. The government alleged that (i) AT&Tís relationship with Western Electric was illegal, and (ii) that AT&T monopolized the long distance market. The DOJ sought divestiture of both manufacturing and long distance from local service. The case was settled by the Modified Final Judgement ("MFJ"). This decree broke away from AT&T seven regional operating companies ("RBOCs"). Each RBOC was comprised of a collection of local telephone companies that were part of AT&T before the breakup. Regional Bell Operating Companies remained regulated monopolies, each with an exclusive franchise in its region.

Microwave transmission was a major breakthrough in long distance transmission that created the possibility of competition in long distance. The breakup of AT&T crystallized the belief that competition was possible in long distance, while the local market remained a natural monopoly. The biggest benefits to consumers during the last fifteen years have come from the long distance market, which, during this period was transformed from a monopoly to an effectively competitive market.

Competition in long distance has been a great success. The market share (in minutes of use) of AT&T fell from 85% to 53% at the end of 1996, as seen in Figure 1. 5 Since the MFJ, the number of competitors in the long distance market has increased dramatically. There are five large facilities-based competitors, AT&T, MCI, Sprint, LDDS-Worldcom, and Frontier. 6 There is also a large number of "resellers" that buy wholesale service from the facilities-based long distance carriers and sell to consumers. For example, currently, there are about 500 resellers competing in the California interexchange market, providing very strong evidence for the ease of entry into this market. At least 20 new firms entered the California market in each year since 1984. At present, there are at least 5 "out of region" RBOCs providing service in California through affiliates. In California, a typical consumer can choose from at least 150 long distance companies.

Figure 1

Prices of long distance phone calls have decreased dramatically. The average revenue per minute of AT&Tís switched services has been reduced by 62% between 1984 and 1996. Figure 2 shows the decline of average gross revenue per minute for AT&T and the average revenue per minute net of access. 7 AT&T was declared "non-dominant" in the long distance market by the FCC in 1995. 8 Most economists agree that presently the long distance market is effectively competitive. 9

Figure 2

A long distance phone call is carried by the local telephone companies of the place it originates and the place it terminates, and only in its long distance part by a long distance company. Thus, "originating access" and "terminating access" are provided by local exchange carriers to long distance companies and are essential bottleneck inputs for long distance service. Origination and termination of calls are extremely lucrative services. Terminating access has an average total cost (in most locations) of $0.002 per minute. Its regulated prices vary. A typical price is $0.032 per minute, charged by NYNEX. Such pricing implies a profit rate of 1500%. 10 Access charges reform is one of the key demands of the pro-competitive forces in the current deregulation process.

Local telephone companies that came out of the Bell System (Regional Bell Operating Companies, "RBOCs") actively petitioned the U.S. Congress to be allowed to enter the long distance market, from which they were excluded by the MFJ. The MFJ prevented RBOCs from participation in long distance because of the anticompetitive consequences that this would have for competition in long distance.

The great success of competition in long distance allowed US Congress to appear "balanced" in the Telecommunications Act of 1996 by esta