Deregulation vs. reregulation of telecommunications: a clash of regulatory paradigms.

• Author: Yoo, Christopher S.

1. Introduction II. Mandating Access to Telecommunications A. First Generation Access: Mandating Access to Local Telephone Systems and Vertical Structural Separation 1. The Inevitability of Rate Regulation 2. The Inability to Realize Efficiencies of Vertical Integration B. Second Generation Access: Local Loop Unbundling 1. Administrative Difficulties 2. The Impact on Investment Incentives C. Third Generation Access: The Ladder of Investment III. The Deregulatory Alternative A. The Emergence of Competition B. Impact on Investment Incentives IV. Deciding Between Regulation and Deregulation V. Conclusion I. Introduction

   U.S. telecommunications policy has reached a crossroads. During the 1980s and 1990s, regulations focused primarily on mandating access to the portions of the local telephone network that still represented a natural monopoly, a policy epitomized by the two great landmarks of modern telecommunications policy: the breakup of AT&T (1) and the Telecommunications Act of 1996. (2) The basic policy approach was eventually extended to broadband networks as well (3) and has been widely emulated by other countries. (4)

   At the prompting of the courts, (5) the Federal Communications Commission (FCC) began to retreat from this policy during the 2000s in favor of a more deregulatory course. In response to the growing levels of competition, the FCC took steps toward eliminating mandatory access requirements on both telephone and broadband networks. (6) Once the 2005 Brand X decision effectively signaled the Supreme Court's accession to this deregulatory trend, (7) the FCC eliminated all access requirements on telephone and broadband systems alike. (8)

   The inauguration of a new administration has caused policymakers to consider once again whether to begin mandating access to broadband networks, as evinced by the continuing controversy surrounding the policy initiative known as network neutrality. (9) This Article reviews the arguments on both sides of this debate. Part II examines the case for regulation, focusing on the rationales and critiques surrounding three separate regulatory approaches: mandating access to local telephone networks, local loop unbundling, and promoting the ladder of investment. Part III lays out the case for deregulation. Part IV sets out the tradeoffs implicit in the choice between these two regulatory strategies.

2. Mandating Access to Telecommunications

   This Part traces the origins of the policy of mandating access to telecommunications networks. The move to regulation takes place in three distinct phases. The first is mandating access to local telephone networks, exemplified by the regime imposed in the aftermath of the breakup of AT&T. The second is local loop unbundling, epitomized by the unbundled network element provisions of the Telecommunications Act of 1996. The third is a theory developed in Europe known as "the ladder of investment."

   1. First Generation Access: Mandating Access to Local Telephone Systems and Vertical Structural Separation

      Since at least the days of John Stuart Mill, one of the central problems usually seen as justifying rate regulation is natural monopoly. (10) Natural monopoly occurs when a single firm can serve the entire market more cheaply than can two firms, a condition known as "subadditivity." (11) A sufficient condition for subadditivity is the existence of scale economies throughout the entire range of production, such as occurs when fixed costs are very high. These scale economies permit the firm with the largest volume to face the lowest costs, which in turn permits that firm to underprice all of its rivals. The resulting transfer of sales volume to the market-leading firm causes its cost and price advantage to widen still farther until it is the only firm remaining in the industry. Thus large scale economies can cause markets that begin with multiple producers to inevitably collapse into monopoly. (12)

      Throughout most of the history of the telephone industry, the fact that telephone service required large fixed costs led most observers to believe that the entire telephone system was a single, fully integrated, natural monopoly. (13) During the 1960s, however, policymakers began to question this premise. For example, technological developments like telephone handsets, fax machines, and answering machines employed by end users, known as customer premises equipment (CPE), (1) 4 were nothing more than small appliances that could be manufactured efficiently at fairly low volumes. In addition, the advent of microwave transmission, pioneered by a company known as Microwave Communications, Inc., (later better known by its initials, MCI) allowed providers to offer long distance service without having to spend the large fixed costs needed to establish large networks of wires. (15) Lastly, firms began to offer innovative new services that combined data processing with traditional transmission. These precursors to the modern Internet, called first "enhanced services" and later "information services," (16) also did not evolve the large fixed costs associated with natural monopoly. (17)

      As these other portions of the telephone network became potentially competitive, local telephone service remained characterized by the high fixed costs associated with natural monopoly. (18) Policymakers became concerned that the continued existence of monopoly over local telephone service would allow the Bell System to prevent the emergence of competition in these other areas of the network. (19) one concern was that local telephone companies could use supracompetitive returns earned in local telephone markets to cross subsidize their own proprietary CPE, long distance, and information services. (20) Another was that local telephone companies would use exclusivity or tying arrangements to foreclose competitive providers of those complementary services. (21) Yet another worry was that the Bell System could avoid rate regulation of local telephone services by bundling them with unregulated services and charging prices for those unregulated services that would allow it to earn the supracompetitive returns denied to them by rate regulation of local services. (22)

      The historic solution was to segregate those portions of the telephone system that still exhibited natural monopoly characteristics (in this case, local telephone service) from those complementary services that are potentially competitive, and to require that the local telephone provider make its network available to all providers of complementary services on an equal basis. (23) Most dramatically, the court order breaking up AT&T required that the Bell System spin off its local telephone and CPE manufacturing operations into independent companies, mandated that the newly created local telephone companies provide equal access to all providers of complementary services, and forbade these newly created local telephone companies from providing long distance, CPE, or information services. (24) The decision was anticipated by both the FCC's 1968 Carterfone decision, which eventually led to regulations requiring the Bell System to open its network to CPE manufactured by competitive providers, (25) and the FCC's Computer Inquiries, which required that large carriers who wished to offer enhanced services do so through a separate subsidiary while offering unaffiliated enhanced service providers nondiscriminatory access to their transmission facilities. (26)

      Requiring potentially competitive and inherently monopolistic lines of business to be structurally separated into distinct corporate entities made it more difficult for enterprises to use profits from their monopoly businesses to cross subsidize business units that faced competition. (27) Structural separation also made discrimination against unaffiliated providers of complementary services easier to police. Regulators could simply insist that local telephone companies offer to competitors the same terms of interconnection that it provided to its own affiliated complementary services. (28) If properly implemented, this approach would allow consumers to enjoy the benefits of relying on competition instead of direct governmental intervention to discipline industry actors, while still protecting consumers against potential anticompetitive abuses in those portions of the industry that remained uncompetitive.

      1. The Inevitability of Rate Regulation

         This solution did come at a cost. Compelling access to a bottleneck facility to promote competition in complementary services is generally regarded as being based on what lower courts have called the "essential facility doctrine." (29) Indeed, the doctrine formed the explicit basis for the breakup of AT&T. (30)

         Leading commentators have noted that the central concern of the essential facility doctrine is vertical integration, specifically that an enterprise that controls a monopoly input may be able to harm a vertically related market by refusing to share it. (31) Indeed, courts and agencies ordering access to local telephone systems and commentators calling for access to last-mile broadband facilities acknowledge that their claims are fundamentally complaints about vertical integration. (32)

         The essential facility doctrine has been subject to extensive and trenchant critique. (33) As an initial matter, the doctrine requires direct regulation of rates. Although some have suggested that these problems can be avoided simply by imposing a nondiscrimination mandate, (34) such a mandate would not prevent a vertically integrated monopolist from simply charging both its own affiliate and competitors interconnection fees that are prohibitively expensive. Doing so would not affect the monopolist's bottom line, since any losses incurred by the complementary services division would be offset dollar-for-dollar by higher profits earned by its local telephone operations. It would, however, effectively lock out competitors. In the absence of...