Is federal preemption efficient in cellular phone regulation?

AuthorHazlett, Thomas W.

Increased regulation of wireless telephone service is being proposed by both federal and state policy makers, raising the question of optimal jurisdiction. The case for decentralization (state rules) is strongest when the economic activity being regulated is localized and market spillovers are relatively small. Alternatively, the case for uniformity (federal rules) becomes more persuasive when externalities dictate that efficiency in one state is closely tied to efficient arrangements in others. In this situation, balkanization becomes disruptive and federalism becomes ineffective as firms conform not to diverse standards, but in the best case scenario, to the most stringent ones. As an empirical matter, wireless telephony exhibits strong economies of scale and scope, and national networks have proven crucial to industry development. Consolidation of fragmented license areas was, along with new entry, instrumental in reducing rates by seventy-nine percent during the 1993-2002 period. (1)

  1. INTRODUCTION

    Some states are considering new regulations for wireless telephone service. (2) Alternatively, federal legislation has recently been introduced to achieve similar objectives. (3) Proposed rules would potentially change marketing practices, alter the information conveyed in newspaper, radio, or TV ads, and stretch the "free trial" periods before "early termination fees" would kick-in (Table 1). The effect on consumers of such measures has been analyzed in previous research. (4) This paper discusses the policy arguments for determining such service rules on a state-by-state basis versus imposing federal regulatory standards.

    Portions of this question have been decided in favor of federal jurisdiction, while other responsibilities have been given to state law. Cellular phone service fundamentally depends on spectrum policies enacted by the federal government. The basic market structure questions--how many firms compete, what technologies they use, how much bandwidth they access, and how they interconnect with other networks-are consequently determined by the Federal Communications Commission ("FCC"). Moreover, the Omnibus Budget Reconciliation Act of 1993 established that "no State or local government shall have any authority to regulate the entry of or the rates charged by any commercial mobile service or any private mobile service." (5) This effectively preempted state regulation of cellular rates with a one-year phase-in, meaning that there has been no federal or state regulation of wireless telephone charges since August, 1994.

    In the 1993 federal preemption statute, however, states were left with jurisdiction over "other terms and conditions of commercial mobile services." (6) How much regulatory authority this cedes to the states is legally uncertain. (7) In equilibrium, it appears clear that there will be some shared responsibilities, with federal jurisdiction for key economic regulations including spectrum-related issues, and state authority over matters that are traditionally decentralized, such as the resolution of contractual disputes in municipal and state courts.

    The question addressed in this paper is where, as a matter of public policy, to draw the line regarding the consumer protection regulations currently under consideration. From the perspective of consumer welfare, and assuming a possible role for regulatory standards, would the standards be most efficiently evaluated and applied by the several states or at the federal government level?

    Two broad sets of marketplace evidence help to answer this question, and both suggest that federal jurisdiction is relatively efficient. The first concerns the efficiency of national scope in wireless networks. The economics of wireless telephony suggest that regardless of the jurisdiction selected for rulemaking, diverse local rules will not effectively determine standards. Rather, nationally integrated network operators will choose to conform to those regulations that allow them the best opportunity to offer nationwide service. This undermines incentives for states to create efficent rules. Either such rules will have little practical impact, or they will create large external effects, meaning that they impact consumers and suppliers outside the political jurisdiction where policies are crafted. Such effects are typically discounted in the decisions of policymakers, resulting in rules that are relatively inefficient. The second set of data is derived from a natural experiment involving a 1994 federal preemption of cellular rate regulation by the states. State controls demonstrably failed to lower rates for customers. Nonetheless, strenuous arguments were made at the time by several state regulatory commissions that such controls were efficient and should be permitted to continue. This speaks directly to the effectiveness of state regulation of wireless telephone service.

    This paper proceeds as follows: Section II sketches a very brief history of the wireless telephone industry. Section III summarizes the general arguments for and against federal preemption in economic regulation. These include examples from other sectors where diverse state rules are efficient and from where uniform federal standards have proven efficient. Section IV investigates the economics of wireless telephone service, producing the key finding that consolidation of an atomistic licensing grid through mergers and operating agreements has produced efficient national networks. This is the service that consumers have demonstrated a keen interest in purchasing. Section V discusses the importance of national wireless network economies in light of the tradeoffs generally associated with regulatory federalism. Section VI examines results from a natural experiment wherein state regulation of cellular telephone rates was preempted in 1994. Section VII concludes that the weight of the evidence argues in favor of substantial federal preemption in wireless telephone regulation.

  2. A BRIEF HISTORY OF THE WIRELESS TELEPHONE INDUSTRY

    A basic description of the wireless telephone industry will aid in the discussion of regulatory options. Cellular phone service began with the issuance of two competing licenses, mostly by lottery, in each of 306 Metropolitan Service Areas ("MSAs"), between 1984 and 1986, and in 428 Rural Service Areas, between 1988 and 1989. (17) This was the result of a rulemaking process formally initiated by the FCC in 1968. (18) The long delays involved regulatory debate over many issues, including how many companies should be licensed and how much spectrum should be allocated for use. The FCC, on an assumption of natural monopoly, initially decided to license just one operator but became persuaded that some competition was possible and that licensing two rivals in each service area would still allow for economies of scale to be realized by each. It allocated various increments of bandwidth, finally deciding to allot 25 MHz (about the same used for four television channels) to each license, with the frequencies to be in the UHF band reallocated from TV channels 70-83. (19)

    The potential of wireless telephone service was vastly underestimated. Through the mid-to-late-1980s, prices for actively traded cellular licenses increased almost monotonically. Beginning trades were just $12 "per POP" (price of the license divided by total population in the market area covered by the license) but by 1988, prices exceeded $135. (21) By 1990, the aggregate nationwide value of the licenses just in the MSAs (covering about eighty percent of U.S. population) was estimated at close to $80 billion by the U.S. Department of Commerce. (22) These large market capitalizations were driven by reinforcing trends within the sector, including strong customer demand for wireless phone service, enhanced network coverage, rapidly falling handset costs, and rapidly increasing handset functionality (including miniaturization and increased battery life).

    Prices were much higher than fixed line service, however, and they had exhibited no substantial decline since the initiation of cellular systems. (23) The duopoly market structure imposed on the industry had established reasonable service, but it was expensive and extremely fragmented owing to the FCC's 734-market licensing grid. This would change as competition and consolidation dramatically restructured the industry.

    Entry was primarily achieved in two regulatory proceedings, the most important being for personal communications services ("PCS"). PCS used smaller cells than traditional cellular systems, as well as digital formats that improved capacity and performance. (24) Formally initiated in 1990, the Commission allocated 120 MHz to six new licenses in the 1.9 GHz band. Two licenses (PCS-A and PCS-B) were allocated 30 MHz each and issued in each of 51 Major Trading Areas ("MTAs"). (25) These licenses were auctioned, pursuant to new federal legislation, in 1995. (26) Four remaining PCS licenses were assigned in each of 493 Basic Trading Areas ("BTAs"). (27) PCS-C was allocated 30 MHz, the rest (PCS-D, PCS-E, and PCS-F) were allocated 10 MHz each. Auctions for these licenses were held in 1996 and 1997. (28) With simultaneous auctions, PCS bidders could aggregate permits to create regional or national service territories, as Sprint PCS did, for example, in winning licenses covering close to the entire country.

    PCS licensees began constructing competing wireless telephone systems just as Fleet Call, now Nextel, was deploying a nationwide wireless network using Specialized Mobile Radio ("SMR") licenses. The plan actually used licenses for local dispatch services (taxis, pizza delivery, etc.), which by means of a strategic regulatory waiver, were permitted to provide wireless phone competition. (35) By accumulating thousands of licenses for such localized services and creating a national network with the right to offer service to the general public, a new...

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