Divestiture and its implications for innovation and productivity growth in U.S. telecommunications.

• Author: Datta, Anusua

1. Introduction

   The Schumpeterian Hypothesis (1) suggests the social cost of monopoly may be a price that must be paid for rapid technological advancement. Thus, there is a tradeoff between "static" efficiency losses, reflected in higher prices and lower output due to monopoly, and "dynamic" progressiveness (Nelson and Winter 1982). Over the long run, however, the gains to society from continuing innovation may vastly outweigh those achieved through competitive pricing. This purported tradeoff has been central to the controversy surrounding antitrust policy in the United States, including the recent antitrust case against Microsoft, which had raised serious possibilities of a breakup of the company. Even though the Microsoft case seems headed for a settlement, (2) it has brought to the fore important questions about the antitrust policy and its effects.

   In that context, the landmark breakup of American Telephone & Telegraph Company (AT&T), less than two decades ago, represents a classic example. It was an experiment aimed at increasing competition and productive efficiency in the U.S. telecommunications industry. Divestiture of AT&T in 1984 split the industry vertically between local and long-distance operations. While AT&T's local operations were divided among seven regional holding companies, AT&T itself was left with a competitive long-distance service. Divestiture also resulted in the breakup of Bell Labs, the centralized research division of the Bell System into two parts--AT&T Bell Labs, which was a part of AT&T, and Bellcore, jointly owned by the seven regional holding companies. Dismantling the monopoly structure of the U.S. telecom industry provides a unique opportunity to examine the effects of antitrust policy on competition, innovation, and productivity.

   Kwoka (1993) and Crandall and Galst (1995) provide preliminary assessments of the impact of deregulation on productivity. These studies use a total factor productivity decomposition approach to study the effects of competition and scale economies on productivity growth. Other productivity studies include Staranczak et al. (1994), a cross-country study including the U.S. telecommunications industry, and Resende (1999), which looks at productivity growth and regulation in local telephones. Almost all these studies show that competition had a positive effect on productivity growth, although divestiture itself seems to have affected productivity negatively.

   There are few known studies that statistically test the effects of divestiture on innovation in the telecom industry. Noll (1987) provides a nontechnical examination of the impact of divestiture on AT&T's research and development (R&D) activities, while Noam (1993) gives a broad overview of the impact of divestiture on prices, service, productivity, and research. These studies indicate that AT&T's R&D outlay, in terms of the number of people employed and the volume of investment, has done well from divestiture. Despite a large body of empirical literature on productivity in U.S. telecommunications, studies have generally ignored the potential link between R&D and productivity growth.

   The present study uses a simultaneous-equations framework to examine the interrelationship between market structure, R&D, firm size, and productivity before and after the breakup of AT&T. This allows us to capture the possible simultaneity that may exist between R&D and productivity and also to statistically test the effects of divestiture on productivity and R&D activities of AT&T.

   Prior to divestiture, AT&T was involved in providing both interexchange toll services and local services. However, since divestiture, AT&T no longer provides local access. This raises the question, is it still meaningful to compare pre- and postdivestiture AT&T? (3) The objective of this article is to analyze the impact of government policy, namely divestiture, on the behavior and performance of AT&T. Government policy action brought about sweeping changes in the telecommunications industry, reducing AT&T from a protected monopoly providing every possible telecom service to one providing only long-distance services. In addition, the market for long-distance services was opened to competition even as local services remained protected. A major argument in favor of deregulation of AT&T was that market forces and competition would improve AT&T's productive efficiency (Noam 1993). At the same time, however, some argued that breaking up AT&T would have dire consequences on research (Noll 1987) as the company was re duced to a fraction of its former self. However, the results from this study show evidence to the contrary. Average productivity for the period 1985-1994 remained below the averages for the previous two decades. On the other hand, despite its smaller size, AT&T's spending on R&D was appreciably higher than before the breakup, which is significant!

   The structure of the article is as follows. Section 2 provides a brief background of the deregulation of U.S. telecommunications and reviews the evidence. Section 3 discusses the analytical framework and the measurement of total factor productivity for AT&T. Section 4 presents the regression model. Section 5 provides estimation and results, and section 6 concludes.

2. Deregulation of U.S. Telecommunications

   The telephone industry in the United States was changed radically on January 1, 1984, when AT&T was divested of its local operations and left only with competitive long-distance services. This marked the end of a century-old monopoly of the Bell System. AT&T served as a vertically integrated end-to-end monopoly, providing almost all long-distance service and much of the local service in the United States. Its monopoly status was fully protected and regulated by the government. However, development of new microwave technology in the 1960s opened the doors to competition, with new companies like MCI entering the long-distance telephone market. AT&T tried its best to stifle competition using its vast resources and market power. This led to antitrust action and its historic breakup in 1984.

   Prior to divestiture, research and development in the Bell System had been centralized at Bell Labs, which had established itself as one of the world's richest sources of private telecommunications research. With the divestiture of AT&T, Bell Labs was broken into AT&T Bell Labs and Bell Communications Research, Inc. (Bellcore). AT&T retained the former, while Bellcore met the needs of the divested Bell operating companies. The divestiture of AT&T raised concerns about the future of research and productivity in the telecom industry. It was feared that fragmentation of the Bell System would result in loss of economies of scale besides greatly limiting the scope and mission of Bell Labs.

   Divestiture and Competition

   Tables 1 and 2, respectively, show the pre- and postdivestiture market shares (4) of AT&T and other long-distance carriers. AT&T had complete monopoly over long-distance services until 1970, when for the first time the market was opened to competition. However, between 1970 and 1983, AT&T's market share fell only marginally, from 100% to 92% (an 8% decrease), as AT&T retained its incumbency advantages with complete control of the networks. Following divestiture, however, the decline in AT&T's market share was rather dramatic. Between 1984 and 1997, AT&T's share of long-distance market share fell from 90% to less than 45%, a loss of almost 50%. In addition, AT&T faced competition from resellers, whose numbers, according to Noam (1993), rose from 42 in 1982 to 597 in 1991. Following divestiture, the provision of equal access to local networks for all long-distance competitors further aided entry and competition in the long-distance telecommunications market (Taylor and Taylor 1993). A look at four-firm concentr ation ratios, however, shows that the telecom industry was still highly concentrated, with the largest four firms accounting for about 80% of the market in 1997. As MacAvoy (1998) notes, there were substantial reductions in concentration from 1984 to 1997; nevertheless, the Herfindahl Index remained between 0.32 and 0.38, representing a market dominated by three large firms.

   Divestiture and Research

   As noted in the previous section, divestiture and equal access encouraged entry, which significantly increased competition faced by AT&T. Spence (1986) points out that competition can have two conflicting effects on R&D and efficiency. It lowers profit margins for firms as entry puts a downward pressure on product prices, thereby creating incentives for firms to carry out R&D in order to lower cost. But competition also causes market shares to fall, which reduces scale economies necessary for firms to reap the benefits of R&D. Thus, the cost savings from R&D may be eliminated by revenue losses due to declining market shares and prices.

   AT&T's toll service rates fell by as much as 45% in real terms between 1984 and 1991 (Noam 1993). The Federal Communications Commission (1991) was quick to attribute reduced rates to competition. However, other studies (5) have argued that the reduction in prices is largely explained by reduction in carrier access charges paid to local telephone companies by the long-distance carriers. This suggests that lower prices did not necessarily translate into lower profits for AT&T. Moreover, despite losing considerable market share during this period, AT&T remained the market leader, with a 45% market share. The effect of these factors is reflected in the postdivestiture R&D spending of AT&T.

   Table 3 presents the figures on AT&T's operating revenues, inflation-adjusted R&D expenditures, (6) and R&D as a percentage of operating revenues (to control for firm size) for the years 1962-1994. A look at these figures, before and after divestiture, shows that R&D has fared well through divestiture. Total R&D spending increased consistently. Most of the increase before...