Leasing the Loop: Telephone Service Resale in the Local Exchange

Fortnightly Magazine - July 15 1996

LEASING THE LOOP:

Telephone Service Resale in the Local ExchangeResellers want steep discounts, but local rates don't always cover costs. And reselling local lines provides little incentive

to upgrade the network.The Telecommunications Act of 1996 (Act) compels local exchange carriers (LECs) to sell telephone service to competitors (em who would then resell to the public at retail. Instead of constructing their own local distribution networks, competitors would buy local telephone service from the existing carrier at discounted rates. The competitor could then "resell" these services to customers (em presumably at prices below prevailing rates for the traditional LECs. In theory, competitors would attract enough of their own customers to generate funds to build their own networks.

Today, some five months after passage of the Act, several state public utility commissions are developing plans to authorize resale of local exchange service. In fact, all states must soon address the issue. Nevertheless, this mandated resale at discounted rates will not necessarily serve the public interest.

Resale is not a recent issue in telecommunications. The Federal Communications Commission (FCC) first allowed AT&T to lease its facilities in the 1920s; resale restrictions for its interstate toll services were removed in 1980.1 Now, resellers and other industry participants anticipate the same benefits from resale of local exchange services that they casually attribute to the resale of long-distance services.2

With the Act mandating local service resale, competitors of established LECs will demand wholesale price discounts large enough to permit resale of LEC services at prices comparable to (and, ideally, lower than) LEC retail rates. LECs will seek wholesale prices high enough to recover their costs. However, by design, certain local service rates (e.g., residential rates in rural areas) are lower than the costs of providing local telephone service. Discounting wholesale prices (without providing some offsetting financial support for universal service) will discourage new investment in physical network facilities and perhaps entirely preclude

facilities-based competitive entry in high-cost areas.

In New York, Rochester Telephone Co.'s "Open Market Plan" sets wholesale prices to competitive providers 5 percent below Rochester's retail rates. In Illinois, Ameritech offers competitors wholesale price discounts of 6 to 10 percent, with steeper term and volume discounts available.3 Pacific Bell's wholesale discounts in California are set at 17 percent for business lines and 10 percent for residential service.

To make competition work, while preserving universal service as prescribed by the Act, state and federal regulators must establish an appropriate set of wholesale prices that will reflect the characteristics of local exchange service.

Long Distance (em The Wrong Blueprint for Local Competition

Supporters of local exchange resale often point to lower prices and vigorous competition (em benefits which they say have emerged from the resale of long-distance, and which (they claim) may also ensue from resale of local services. Yet, the two products cannot be compared. Local and long-distance telephone service exhibit vastly different market structures.

Long-distance providers offer

a host of volume- and term-discounted pricing packages to resellers and customers alike. Steep discounts are possible because 1) toll prices historically have been inflated to help support low local exchange rates, and 2) the marginal costs of carrying traffic over the long-distance network are low. Pure long-distance resellers aggregate traffic from many small users that would not individually qualify for the larger volume discounts, and purchase bulk usage over the long-distance provider's shared network at discounted prices. Because resellers exert no control over the price charged by the underlying facilities-based carrier, these firms can exist only where they can take advantage of the legal price discrimination prevalent in the long-distance market.

Resale of basic local service is markedly different. Local service consists primarily of two components: 1) access (the so-called "local loop" with dialtone), and 2) usage within the local calling area. With resale, the LEC sells the entire service (dedicated loop and usage combined) to the reseller, presumably at a discounted price. The LEC continues to own and maintain the facility, but relinquishes complete use of the entire facility to the reseller (em not merely a share of capacity, as is the case with long distance. The LEC reseller in effect resells the capital asset. However, basic local exchange service prices generally do not cover the underlying costs of local loops. Resale of local service affords no positive margins from which to offer price discounts that mirror those available in the long-distance market.

The long-distance market provides little evidence that any significant number of resellers have actually made the transition to constructing their own networks. Out of 465 long-distance carriers, only 7 actually serve 45 or more states.4 Most carriers serve only one state, and provide nationwide service by reselling services purchased from other carriers.5

Furthermore, resale of long-distance services did not play an essential role in promoting competition in the long-distance markets, as resale is now asked to do for local services. MCI, for example, had already entered the long-distance market before resale restrictions were lifted. By the end of 1975, MCI had spent $106 million in constructing an intercity microwave network,6 which allowed it to compete in the long-distance market even without resale.

Steep Discounts (em Won't Encourage New Construction

Although the Congress has now assigned a duty to LECs to resell local telecommunications services, mandated resale will not automatically serve the public interest. Arbitrary discounts (larger than the net costs avoided through resale) distort the market and send the wrong pricing signals to potential facilities-based entrants. Excessive discounts would retard, if not foreclose, entry by facilities-based carriers. Such discounts would create the perception that the LEC performs the functions that are not related to retailing at a lower cost than the LEC actually incurs. That image would likely keep alternate providers from deploying their own facilities, even those who are equally or more efficient than incumbent LECs. Clearly, efficient competitors find no incentive to build their own facilities if they can lease capacity from an incumbent LEC at prices discounted below their own network construction costs. In addition, LECs have no incentive to upgrade or expand their networks, if forced by regulation to resell these facilities at excessive discounts.

Regulators now face the difficult task of setting the optimal wholesale price for resold services. In this effort, they should be guided by the principles of economic efficiency. Recent work in this area shows that the optimal wholesale price is the retail rate, minus the avoided incremental cost of retailing, plus the incremental cost

to the LEC of engaging in

wholesale.7 Resellers should also pay a fixed charge designed to recover the fixed and per-company setup costs of making resale possible. Given such a wholesale price, LEC and reseller prices will properly reflect their relative abilities to compete in retail sales at the lowest cost. This method of pricing the wholesale service is equivalent to the efficient component-pricing rule for intermediate productive inputs.8

Local Subsidies (em At Odds

With a Resale Policy

The pricing rule described above relies on the existing LEC retail rate as a basis for developing the wholesale price. It will prove optimal only if existing LEC prices represent true retail prices (em prices that cover all relevant costs and contribute to overhead. Unfortunately, that is not always the case in telecommunications.

Within the telephone industry, regulators have traditionally held local service rates at artificially low levels to foster universal service. They did so first with a policy of "residual pricing (em keeping prices as high as possible for long-distance and other discretionary services to support low local rates. Geographic averaging over the entire service area also held prices low in high-cost areas. Thus, regulators have set rates far above cost for long-distance, discretionary, and basic exchange business services in metropolitan areas (em all to hold rates below cost for basic residential calling.9 In addition, many states have adopted price ceilings or outright price freezes on basic local service rates. Consequently, existing LEC prices for local telephone service do not necessarily reflect market-based retail prices and cannot serve as the starting point in developing a wholesale price for local service.

Further, a resale policy makes sense only if market power has forced retail prices too high and competition from resale would curb that market power. The opposite holds true in the subsidized residential and small-business markets.

Entry into these subsidized markets appears economically attractive only because it gives providers (LECs and resellers alike) a first crack at services priced far above cost, such as vertical features and long-distance services. In a one-stop shopping environment, customers will likely prove predisposed to purchase most, if not all, of their telecommunications services from the same provider to which they subscribe for basic local service. By requesting a discounted wholesale rate in a market that is already subsidized, resellers are essentially demanding an equal shot at the high-margin markets, where they can undercut the LEC's artificially inflated prices without having to bear any of the costs that justify current price levels.10 A wholesale rate that lies below the actual cost of service will ultimately require the LEC's customers or stockholders to subsidize the reseller's customers. The remedy is obvious: In the public interest, regulators should set the price of retail services so that the resulting discounted wholesale price does not fall below cost.

Prospective resellers, notably AT&T, argue that modest wholesale discounts fail to make entry worthwhile, that they simply cannot make a profit at such "high" wholesale prices.11 However, according to mainstream economics, if wholesale prices properly reflect LEC retail rates less net avoided costs from resale, a reseller's profit will depend solely on its ability to perform the component functions of retail sales (marketing, customer care, and the like) more efficiently than the incumbent LEC. Since the sales function is the only production component that the reseller performs and controls, performance in that area should determine profitability from resale.

Steep discounts not justified by the net avoided costs incurred by LECs would further reduce the LEC's local service revenues and increase the amount of the required subsidy, solely to benefit the reseller's financial condition. In addition, the LEC would likely lose the revenues from toll and other discretionary services it no longer provided over the resold loops, particularly if the reseller combines the LEC's resold service with its own long-distance and other facilities. Thus, the LEC would face a greater revenue shortfall in local service, as well as reduced revenues from the sources that traditionally generated support. On the other hand, resellers would receive further subsidies in the form of non-cost-supported discounts to a service already priced below cost.

Market Incentives (em Skewed by Inefficient Resale

As they seek to implement the new telecommunications law, regulators must bear in mind that resale can offer an effective policy only if it leads to increased efficiency and improved competition in retail markets. If resale is

implemented without regard for economic efficiency, economic incentives may become skewed. For example, if LECs are required to pass on service improvements and cost savings to resellers, they will find little incentive to increase quality, upgrade existing facilities, or lower costs.

The goal of the Telecommunications Act of 1996 is to foster competition. Resale offers just one means to that end. As competition develops in the retail market, the need to regulate retail prices will diminish. The incumbent LEC, resellers, and alternate facilities-based providers should all be able to price their retail services based on market conditions. In this way, retail prices will properly reflect efficiency improvements due to the competitive process (em as will the wholesale prices derived from retail rates. Regulatory restrictions in the retail market would then become counterproductive.

Resale allows new entrants to purchase production components they cannot readily provide, at least not efficiently, and perform only the retail sales function generally available to all providers. If too deeply discounted, the wholesale price veils the true social costs of entry. The LEC would have to assume all the expense and risk of investing in telephone plant, while resellers could use the investment at low prices and walk away with no losses if consumer demand proves inadequate. This setup will not bring about real economic efficiencies and the type of competition that lowers total industry costs. t

Terrence J. Schroepfer and Margarete Z. Starkey are economists in Southwestern Bell Telephone Co.'s Regulatory and External Affairs Department in St. Louis, MO. Mr. Schroepfer has an MA in economics from the University of Missouri. Ms. Starkey has an MA in economics from Southern Illinois University at Edwardsville. The opinions expressed in this article belong solely to the authors and do not represent or reflect the opinions, policies, or business plans of SBC Communications, Inc. or any of its affiliates or subsidiaries.

1. Regulatory Policies Concerning Resale and Shared Use of Common Carrier Domestic Public Switched Network Services, 83 F.C.C.2d 167 (1980) (Resale of Switched Services); recon. denied, 86 FCC 2d 820 (1981). Resale of private-line services was first allowed by the FCC in 1976, resale of cellular services in 1981, resale of intrastate WATS in 1983, and resale of commercial mobile radio service systems in 1995.

2. For example, FCC chairman Reed Hundt stated "resale can be a very effective way to get competition." See, "FCC's Hundt Optimistic On Reform," Inter@ctive Week, Vol. 3, No. 5, p. 49 (Mar. 11, 1996).

3. Ameritech negotiated steeper wholesale price discounts with US Network Corp. and MFS Communications Co., Inc., after obtaining specific term and volume commitments.

4. FCC, Industry Analysis Division, Long Distance Carriers and Code Assignments, p. 9 (May 1995).

5. Id. at 2.

6. William A. Brock and David S. Evans, "Creamskimming," Breaking Up Bell: Essays on Industrial Organization and Regulation, p. 87 (David S. Evans, ed., 1983).

7. See, Alexander C. Larson, "Resale Issues in Telecommunications Regulation: An Economic Perspective," Mich. Tel. & Tech. L. Rev. (forthcoming 1996). Also, A.C. Larson, "Optimal Resale Policies for the Telecommunications Industry," Nov. 1995 (unpublished manuscript on file the authors).

8. William J. Baumol and J. Gregory Sidak, Toward Competition in Local Telephony, MIT Press and American Enterprise Institute for Public Policy Research (1994). Also, Baumol and Sidak, "The Pricing of Inputs Sold to Competitors," 11 Yale Journal on Regualtion, p. 171 (1994).

9. Alfred E. Kahn, "A Free Ticket to Rich Telecom Markets," Wall Street Journal, Nov. 10, 1995, at A17. See also, Jerry Hausman, Timothy Taridf, & Alexander Belifante, "The Breaking Up of AT&T and the Changes in Telecommunications Regulation: What are the Lessons? The Effects of the Breakup of AT&T on Telephone Penetration in the United States," 83 American Economics Review 178, p. 178, n.2 (1993); Leland L. Johnson, "Competition and cross Subsidization in the Telephone Industry," xi (Rand, December 1982) (Rand Document R-2976-RC/NSF).

10. Kahn, supra, note 9.

11. In Re Petition of Rochester Telephone Corporation for Approval of Proposed Restructuring Plan and Petition of Rochester Telephone Corporation for Approval of a New Multi Year Rate Stability Agreement, State of New York Public Service Commission, Case Nos. 93-C-0103 and 93-C-0033, AT&T Communications of New York, Inc., Complaint, Petition for Declaratory Judgment and for Reconsideration of Opinion No. 94-25, pp. 4-5, Oct. 3, 1995.

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