A century ago, Congress conveyed valuable public property to certain entrepreneurs to serve the public interest. In exchange, these entrepreneurs agreed to carry the nation's principal means of communication at fair cost and, of course, serve the national defense.
In 1850, with a commitment to move the mail at fixed rates and freely transport federal troops hither and yon, a swath of public land was granted to the Illinois Central to connect Chicago with Mobile. As with a modern-day scrap over a sports franchise, Chicago went "mano y mano" with St. Louis, while Mobile took on New Orleans as a seaport. Mississippi River traffic, principally steamboats, encountered its first technological competitor.
Railroads were already some 30 years in development. With fewer rivers up-country, a shift to rail-based transportation proved essential to further westward expansion. By 1870, this rail policy helped win the war against slavery, established the supremacy of federal authority, and pumped 131 million federal acres into private hands. Another 27 million Texas acres reserved from federal trusteeship also entered private ownership on similar terms.
Rail Franchises: Priming the Pump
Such grand government giveaways exemplify the "prime the pump" theory of innovation: Use public assets to induce private investment to serve the public interest. A natural corollary is that free markets have short planning horizons, and cannot properly value opportunity. The argument that scale and scope make railroads "natural" monopolies added a dash of legitimacy.
But perhaps private markets did properly value early rail investment. Manifest Destiny aside, why should private capital chase some crazy railroad investment in direct competition to established water-borne traffic between St. Louis and New Orleans? Mississippi river traffic was quite cost-competitive in 1850 (em 40 cents per ton-mile. By comparison, railroad tariffs back East were almost 5 times higher (em $1.90 per ton-mile. [Local exchange carriers (LECs) might compare the cost ratio of wireline and cellular services.]
The actual value of the federal land grant was a small portion of total railroad capital (em 5 percent of total investment from 1850 to 1880. Still, the scale, risk, large fixed costs, and network market structure literally screamed "natural monopoly" (em code word for "franchise." Facing this new franchise were the steamboats, and in 1850 they were a great success story. Steamboat productivity tripled from 1820 to 1850. They owned the market. Illinois Central was going after one tough competitor.
But as more railroads were constructed after 1850, steamboats reached limits of capacity, and productivity growth hit a plateau. Rail absorbed much of the excess demand. Railroad's total factor productivity picked up where steamboats left off (em doubling from 1850 to 1890. Total rail mileage (capacity) grew 15-fold over that same period.
Rail's sustained productivity growth and capital displacement offers a model for effective penetration strategy by a technological innovator (em and a warning to any market defender constrained by capacity limits and aging technology. Rail productivity growth averaged 2.6 percent per year between 1840 and 1910, approximately half from technological innovation alone. For example, steel rails increased useful track life eight times, slashing maintenance cost while boosting load capacity over a right-of-way and making larger engines and rail cars possible. By 1910, steel rails accounted for almost
$500 million in savings (em 80 percent of railroad net income that year.
Increased steel demand generated significant supplier scaling and innovation effects, collapsing steel prices. For example, 1880 iron prices were $48.25 per ton, while steel sold for $67.50 per ton. Just 3 years later, steel prices had fallen below iron. Not surprisingly, rapid diffusion followed. By decade's end, 80 percent of U.S. rail capacity was steel, compared to 30 percent at the start. Public access exploded. Lower costs meant lower prices. Freight prices dropped faster than costs, falling from $2 per ton-mile (1850) to $0.165 per ton-mile (1870) to $0.075 per ton-mile (1910).
The railroad franchise delivered on its promises, and then some. As a wealth creator, railroad land grants were among the more effective policies of the 19th century. Land grants shifted risk from a financially weak government to better-financed private sources.
Lotteries and Auctions: Encouraging Innovation
Let us now consider the present, with its aging franchises and emerging competitive markets driven by technological innovation. The franchise era is ending for many technologies.
"Competition" among franchises is really oligopolistic, insulated by perfect entry barriers. Hence, winning a cellular lottery was better than winning at Powerball. Over 30 million cellular phones are in use today, and cellular grew at a 46-percent annual rate through mid-1995 (em compared with Gross Domestic Product-level growth rates for telephone access lines. Twelve-month revenues through mid-1994 were $8.7 billion. Capital investment rates continue to post annual records (em $2.8 billion in the first six months of 1995, and $21.7 billion since 1983. A success story, with more to come.
Market subsidies and franchises are not needed to "prime" this kind of investment. And, so, burned once on the cellular lottery, the feds have turned to auctions to commercialize demilitarized spectrum above 1 gigahertz (em with spectacular success. New wireless technology will be introduced in spectrum blocks won through multiround competitive auction for personal communications services (PCS), satellite constellations, wireless video, and other wireless services. Spectrum auctions raised close to $7 billion in license fees alone in recent years.
Mindful of the political/public service elements, the Federal Communications Commission (FCC) auctions address the "hot button" issues. Acting as a market manager, the FCC ensures a solvent service provider, set-asides for pioneers and entrepreneurs, cash up front, and timetables for rapid capacity buildout to near full coverage ("use it or lose it"). Other restrictions protect against undue concentration of market power, and provide for minimum bids.
Two auctions are currently underway: Multipoint and/or Multichannel Distribution Service (MMDS or MDS), and Frequency Block C for the PCS. In the MDS auction, up to 493 licenses will be issued for wireless video services competing with CATV, broadcast, and DBS services. In the PCS auctions, the same number of entrepreneur licenses will be auctioned to compete, replace, or supplement wireline services. PCS also competes with paging and cellular.
The business theory behind the auction recognizes current market constraints (em clear access to the customer. Consequently, bidders are purchasing the right to enter a market. High bid wins the license, and admits the winner to "The Show." Fees generally correlate with population size (expressed on a per capita or "per-POP" basis). This modern notion of "potential customer access" auctions suggests an approach to recovering costs for displaced franchise assets.
Since current marketing science places a value on a customer gained, held, or accessed, shouldn't new service providers pay for the right to approach a potential customer developed by a current franchise holder? In the retail wheeling situation faced by power companies, rather than employing traditional regulatory approaches to establish "fair and reasonable" connection costs, why not permit the power company to simply auction the right to access its distribution system to service a customer? And to address collocation and bypass issues in telephony, why not permit LECs to auction access to the local loop?
Utility Deregulation: Bringing Valuation to Market
Auctioning market access offers regulators a less expensive market management process than cost accounting. It is not evident that cost accounting is a practical way to value access. For example, in U.S. v. AT&T, the Department of Justice took deadly aim at cost-accounting methods in challenging AT&T's claim to a natural monopoly. Justice argued that managerial diseconomies at AT&T were not addressed in their engineering and productivity studies. Engineering economies of scale aside, Justice claimed that such bureaucracy unnecessarily raised costs and undermined any potential natural monopoly. Besides, since the Bell System decentralized much of its network planning and operation anyway, AT&T's natural monopoly argument was moot in practice.
These arguments of a decade ago have some validity today. They highlight the difficulties in proper cost allocation for control office assets (LECs) and centralized assets (utility transmission and distribution). Not surprisingly, LECs claim the regulatory compact must be made good over asset life, while entrepreneurs argue that aging technology is overvalued in the first place.
The problem might be resolved with a more contemporary notion of wealth. In the 19th century, land was wealth, and capital was scarce (em hence, the franchise. Today, wealth comes in more sophisticated forms (em spectrum, access rights, franchise rights, siting permits, intellectual property, even patents and copyrights, and licenses in general.
In the 19th century a single entity, the federal government (and Texas), owned the land (em today, modern "land" is held by government and private interests, sometimes jointly. In the past, public policy did not have to consider market harvest. Today, effective public policy cannot undervalue the private component, or overvalue aging assets without depressing the market (em and the public interest.
Local regulatory agencies must update their views and offer utilities incentives to be market innovators, rather than capital accumulators. Such a policy would lead to expedited asset writedowns to market value, and also assist utilities in redefining themselves. On the power side, however, competition remains mostly "seminar-speak" due to regulatory lag (em the pain has yet to fully hit. Perhaps the Federal Energy Regulatory Commission's rulemaking on open access will expedite the process. Until then, saddled with rate-of-return regulation, many power companies will stop their competitive repositioning when they finish hunting around for nonessential workers to downsize.
When all the staff is gone, the fixed costs remain. Regulatory agencies need a real policy. There are practical limits to management options when power companies must market their securities to "widows and orphans." With such capital customers, and 15 to 20 years of depreciation still to go on installed assets, cutting the dividend and writedowns to market can offer a quick ticket to the golf course for some chief executive officers (CEOs). Since most CEOs average five years at the helm, utility balance sheets will remain sticky (em perhaps until it's too late.
Auctions, however, rapidly introduce competition without distorting or dislocating the market. A multiround auction can achieve maximum valuation for market access, on a short timetable. Winners gain rights to access the existing utility's assets and customer base under prescribed conditions. The license fees could go toward the utility's stranded investment, or perhaps fund a market-exit strategy.
As the FCC has demonstrated, public service and reliability issues can be readily accommodated within an auction scheme. Access conditions to a license could include an obligation to satisfy whatever public-service conditions the regulator deems appropriate (e.g., lifeline services, billing standards). An auction service fee to the regulator could also fund enforcement and market-management services provided by government in its referee role.
Cutting to the Chase
Two hundred years of auctions demonstrate the superiority of market solutions, and the inevitable triumph of new technology over underperforming assets. Auctions expedite introduction of innovative technologies on a distributed basis, effectively rationalize capacity, and correct market valuation to current levels. Auctions have also proven most effective in serving the public interest.
If we continue our current track to power deregulation, we all can use our PCS handsets and wireless video conference systems to debate what it means to existing assets. By then, however, technological development will have found a way for demand to avoid current inefficiencies (em leaving some balance sheets high and dry, with no place to go. t
Stephen Maloney is president of Devonrue LTD, a technology consulting firm that provides advanced computer simulations of multicompetitor markets for telecommunications and energy firms. Mr. Maloney has over 20 years' experience in the energy, communications, and semiconductor industries, and degrees in physics, mathematics, and operations research.
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