An efficiency analysis of contracts for the provision of telephone services to prisons.

• Author: Carver, Justin

1. INTRODUCTION

   The prison population in the United States has dramatically increased since the 1970s, and as recently as 1998, there were nearly two million inmates incarcerated in the United States. (1) As the numbers of prisons and prisoners continue to increase, so does the market for prison services. Indeed, the prison industry has already grown into a multibillion-dollar industry with its own trade shows and trade newspaper. (2)

   One of the more lucrative segments of this industry is the telephone market. In the prison context, the state contracts with a private entity, and the private entity provides services to the prisoners and also to the state. To the extent that the services are provided to the prisoners, the relationship resembles a third party beneficiary contract. Due to the perverse financial incentives and the political climate surrounding prisons and prisoners, however, neither the state nor the private entity acts in the best interests of the consumers in particular or of society in general.

   With respect to the financial incentives, it is estimated that inmate calls generate a billion dollars or more in annual revenue. (3) One prison pay phone can generate $15,000 annually; a typical public pay phone generates only one-fifth of that amount. (4) Faced with the possibility of such revenues, MCI installed its inmate phone service in prisons throughout California at no charge to the state. (5) As part of the deal, in exchange for the right to be the sole provider of telephone services to the prisons, MCI pays the California Department of Corrections a 32% share of all revenue derived from the calls. (6) MCI adds a three-dollar surcharge to each call. (7) The California example is by no means unique; it is the rule, rather than the exception.

   This Article will analyze the efficiency of these contracts, introduce alternate arrangements, and compare the efficiency of the present contracts to the alternatives. In so doing, this Article will demonstrate that the present contracts are inefficient. More specifically, Section II discusses problems that are unique to the provision of phone service to prisoners, and introduces the practical shortcomings of the current contracts. The Telecommunications Act of 1996, the source of Federal Communications Commission ("FCC") regulatory jurisdiction, is discussed in Section III. Section IV introduces a few basic principles used in performing an efficiency analysis. Section V uses payoff matrices and game theory to demonstrate how the award process for the contracts causes inefficiencies to arise and perpetuate indefinitely. Section VI introduces alternate contract structures and demonstrates that certain alternatives are more efficient than the present contracts. Section VII contains a brief conclusion that calls for the FCC to adopt regulation that preempts existing state contracts which are inconsistent with the most efficient alternate structure.

2. NATURE OF PRESENT CONTRACTS

   1. Exclusive Provider Provisions

      The contract between the telecommunications provider and the state typically provides that the telecommunications provider will be the sole provider for a particular prison or prison system. (8) Parties to these agreements often cite the high costs of the security systems associated with the operation of a phone system in a prison as justification for the exclusive-dealing provisions. (9) Stated differently, the asserted justification is that the market is a natural monopoly, or a market that "can be served most efficiently by a single incumbent firm." (10)

      There are two reasons why the market is believed to be a natural monopoly: (1) the provision of telecommunications in general is best accomplished by one firm; and (2) the costs of the security system make it impracticable for more than one firm to service a prison. The first reason is based on bad economics, and as a matter of public policy, it has been abandoned by Congress. (11) The second reason is factually unsubstantiated as well as pretextual. At least one state, New Jersey, has authorized competition in the provision of telephone services to inmates, and in so doing, the only articulated concerns were security related. (12) The New Jersey Board articulated no "efficiency" concerns.

      The truth is that states stand to earn additional revenue when a monopoly is providing the service, because the state will receive both a commission and tax revenue based on the monopoly profits. (13) In fact, most states are not responsible for operating the security system; that task is delegated to the service provider. In 1998, New York estimated that the annual cost of overseeing the maintenance of the phone system, including the security system, was a mere $283,000. (14) Incidentally, the New York State Department of Correctional Service receives a 60% commission from MCI in exchange for granting MCI the right to be the sole service provider to prisons in New York. (15) In 1998 alone, the Department received $25 million pursuant to this arrangement. (16) The Department has received approximately $68 million since the inception of the arrangement. (17) States often earn tens of millions of dollars in annual revenue from the telephone agreements, as do the telephone companies.

      States also seek to justify the exclusive dealing provisions by asserting that there is competition for the award of the contract, and the threat of competition for the contract encourages the telephone service provider to act as though there is competition for the provision of the services. This argument is based on the theory of contestable markets. Where the identity of a monopolist is determined by a competitive bidding process, and where there is no collusion among bidders, the theory of contestability holds that the price charged by the monopolist will approximate that which is charged in a competitive market. (18) Because the price charged by the monopolist is substantially similar to the price that would be charged in a competitive market, there is no need to regulate the monopolist. (19) There are a number of problems with the application of the theory to this situation. First, note that for the theory to function properly, the bidding for the contract must be renewed regularly, because once a firm begins operating in the market, there is no incentive to price competitively. (20) It is also important to note that contestability has not worked well where the sunk costs are high, as they are here. (21)

      More crucially, the manner in which these contracts are actually awarded does not fall within the traditional understanding of the contestability theory, which presumes that the contract will be awarded on the basis of cost and/or quality of service. Here, the contracts are usually awarded solely on the basis of which company will provide the state with the largest commission, and not on the basis of which company will provide the services at the lowest price. (22) As the award process does not create an incentive for the firm to behave competitively, this practice is not in accord with the economic theory of contestability.

   2. Calling Options

      Even where prisoners are required to place all calls through a particular provider, prisoners generally do not have the ability to choose between multiple calling options. The vast majority of states require that all calls made by inmates be made "collect," and therefore it is the prisoner's family or friends who actually pay for the call. (23) Prepaid calling cards are generally banned for fear that they contribute to or further a black market for contraband. (24)

   3. Cost of Calls

      The cost of the phone calls varies from state to state, depending on the amount of the surcharge imposed by the company, the amount of the kickback to the state, and the amount of the cap to which the rates are subject. In some states, the rates charged by the telephone company for collect calls made from prisons are capped at the rate that would be charged on collect calls made from a pay phone outside of prison. (25) Of course, the surcharges do not count against the cap, so the actual rate charged for calls from inside a prison still exceeds the rate charged on external calls.

      It is also important to note that telephone companies are often required by regulatory authorities to install and maintain a number of public pay phones in the area served by the phone company. (26) The installation of these pay phones is considered by regulators to be a compulsory public service, and this service is made mandatory by regulators who believe that greater access to pay phones increases public access to 911 emergency service. This requirement is very unpopular with telephone companies, which are often required to install and maintain pay phones in unprofitable locations with low call volume. (27) Regulators have generally been responsive to these concerns and have allowed telephone companies to increase the rate charged on all pay phones, effectively allowing the unprofitable pay phones to be subsidized by the profitable ones.

      As noted above, prison pay phones have an inordinately high amount of call volume, as compared to public pay phones. Where the rates are capped, they are often capped to match the highest of the rates charged by a firm providing service outside a prison. (28) Also, depending on the state, the cap inside the prison does not necessarily reflect time of day discounts. (29) Therefore, even where the rates for collect calls from prisons are capped at the "outside" rate, the inside rate cap is based on false assumptions about phone use in the outside market. As a result, the charges for the inside calls are disproportionately higher than the cost. Inmate challenges to the rates are generally unsuccessful. (30)

      In other situations, the rates are not capped in such a manner that they correspond to the rates made for outside calls. (31) Because the state is not paying for the calls, it seems reasonable...