Rivalrous telecommunications networks with and without mandatory sharing.

• Author: Hazlett, Thomas W.
• Position: Telecommunications Act of 1996: Ten Years Later Symposium

1. INTRODUCTION II. NETWORK SHARING RULES PURSUANT TO THE TELECOMMUNICATIONS ACT OF 1996 III. TESTING THE "STEPPING STONE" THEORY A. Growth in CLEC Lines B. Cable Telephony: The Dog That Didn't Bark. IV. INVESTMENT AND NETWORK SHARING IN TELECOMMUNICATIONS MARKETS A. Wireline Telecommunications Investment B. Telecommunications Regulation and Investment Decline C. Regulated Resale as a Business Model D. Revealed Policy Preferences of Equipment Suppliers V. WIRELESS NETWORKS A. Fixed-to-Mobile Substitution B. Spectrum Allocation C. State Regulation of Cell-Phone Rates D. Resellers in an Unregulated Market VII. CONCLUSION I. INTRODUCTION

   The 1996 Telecommunications Act ("1996 Act"), passed with bipartisan support, aimed to overturn the existing regime of regulated monopoly. Competition would be introduced, and regulation would fade away. Rival networks would then provide the consumer protection long delegated to state and federal agencies.

   Elements of this strategy were cleanly implemented and have proven effective. These include two important policies to assist new network formation. The first was a federal preemption of state-issued franchise monopolies in local telecommunications. Most states had permitted but one operator, per area, to offer local phone service. In addition to other advantages, this measure instantly allowed 11,000 locally franchised cable TV operators to compete in a head-to-head rivalry with local exchange carriers ("LECs"). A second competitive strategy was an interconnection mandate, meaning that new networks would be able to exchange traffic with existing networks, thus facilitating entry. These rules enabled the emergence of hundreds of competitive local exchange carriers ("CLECs") in the aftermath of the 1996 Act. (1)

   The third strategy, however, has proven more problematic and will be the focus of this Essay. To assist the emergence of competition, the 1996 Act decreed that firms were to be given the opportunity to serve local phone customers without building physical network infrastructure, sharing the facilities owned by incumbent local exchange carriers ("ILECs"). If negotiations over wholesale rates proved unsuccessful, regulation would provide a solution. Competitive entrants would be offered each unbundled piece of existing phone networks (e.g., local loops and switching) at prices set by the government. Regulated wholesale access would be a stepping stone for new networks, which would then have the economic ability and incentive to construct new facilities of their own.

   The object of this approach was not retail competition on the reseller model, which with wholesale price controls--transferred fundamental economic planning from capital markets to governments. Rather, the aim was to create new physical networks by incentivizing infrastructure build out. The 1996 Act was clear on this point, as federal courts have held, yet it downloaded sufficient transition management responsibility to the Federal Communications Commission ("FCC") and state public utility commissions for the policy to become conflicted. Regulators found their authority over price controls a tempting source of rent redistribution. Wholesale access terms were imposed to create retail competition by disrupting the crucial signals sent by retail customers to capital markets. The long-term adjustments prompted by nominal price reductions were largely external to the calculus of decisionmakers in this process, a nonmarket failure.

   The central contradictions of the regime were manifested in the costs and benefits flowing from favorable resale terms offered CLECs to use the networks owned by ILECs. Terms making resale entry attractive simultaneously undercut incentives for entrants and incumbents to invest in fixed infrastructure. There is a theoretical argument that, while wholesale price regulation may induce some disinvestment in local telephone networks, this effect can be fully offset by strong economies of scope between retail service and infrastructure ownership. (2) Given a quack and economical way to market services using the incumbent's network, the entrant is advantaged in ultimately creating its own. This prospect will, in turn, push incumbent network owners to invest in upgrades, as well. But this policy needle is difficult to thread.

   Gerald Faulhaber has reviewed the historical experience of "policy-induced competition" in telecommunications. (3) In some episodes, such as the opening of the phone equipment market, the mandate of a modular access point--typified by the now familiar telephone jack--worked to promote competition. The key was that the regulated border between the incumbent's network and the new rivals' interconnection was simple to define. It was a natural border.

   In more complicated interfaces, however, results have been disappointing. Faulhaber classifies the post-1996 Act unbundling rules as intensely complex, artificial, and not likely to succeed. Richard Epstein sees economic incentives as exacerbating the informational requirements stressed by Faulhaber. (4) The incentives for cooperation achieved in contracts are absent when regulators imposed forced marriage on ILECs and CLECs.

   Alfred Kahn sees political actors engaging in the rent seeking game that ensues. (5) By creating mechanisms to redistribute income within the industry, political coalitions form to claim the rents at stake. Firms are rewarded for political support when rules are adjusted in their favor, and firms targeted for potential appropriation find it profit maximizing to increase their political investments for defensive purposes. This results in higher returns to those who influence the regulatory process. (6)

   The evidence from telecommunications markets supports the view that mandatory network sharing has effectively blocked the transition it was advanced to assist. Conversely, the transition to competitive networks anticipated in the 1996 Act has been largely achieved, albeit through the development of alternative telecommunications systems not aided by mandatory network sharing rules. Competition has proceeded outside in, not inside out. The emergence of what Faulhaber calls "category killers" is now facilitating a transition to competition in local telephony.

   These marketplace alternatives have been delayed by distractions and impediments erected under policy-induced competition. Hence, the legal collapse of that regime is welcome in the marketplace. Of key significance is the March 2, 2004, opinion rendered in the case of United States Telephone Association v. Federal Communications Commission (USTA II), (7) which--with the June 9, 2004, decision of the FCC not to appeal that opinion to the U.S. Supreme Court (8)--overturned essentially the entire regime for unbundled network elements ("UNEs").

   This Essay reviews evidence yielded by a series of natural experiments that permit evaluation of comparative institutional mechanisms for encouraging telecommunications competition. First, the pattern of entry by CLECs is examined. These data suggest that resale competition achieved via unbundling regulation does not lead to additional facilities-based entry, but tends to displace such activity. Deployment of cable telephony, for instance, slowed just as unbundled network elements-platform ("UNE-P") line growth accelerated, and then accelerated with the collapse of the UNE-P regime. Second, according to the stepping stone theory, capital expenditures by networks are predicted to rise with unbundling. In fact, investment flows fall dramatically in the sector for both incumbents and entrants as network sharing increases. This pattern cannot be explained solely by the business cycle, as it is distinct from that observed in adjacent markets where different sharing rules apply.

   Third, alternative policy regimes suggest that competition is viable in the absence of mandatory network sharing. In residential broadband, the least regulated medium, cable modern service, has consistently outperformed its direct rival--digital subscriber line ("DSL") service--provided via local exchange carrier networks. When DSL service was partly deregulated in early 2003, however, the broadband race markedly intensified. DSL penetration increased in absolute terms and relative to cable growth, an outcome inconsistent with the view that network-sharing mandates promote investment or deployment.

   In wireless phone markets, competitive entry proved highly effective once personal communications service ("PCS") operators were licensed, beginning in 1995. Nominal retail prices fell approximately 79% in the 1993-2002 period (from $0.57 per minute to $0.12) with minutes of use rising 3158% (from 19 billion minutes to 619 billion). (9) State rate regulation was preempted in August 1994, allowing comparison between competing regimes. Cellular rates did not exhibit a post-deregulation "fly-up," showing that the rate control scheme--which included wholesale prices to facilitate reseller competition in retail markets--was ineffective. When PCS entry occurred, however, rates fell dramatically, both absolutely and relative to trend, providing further evidence of the effectiveness of facilities-based competition. The emergence of competitive wireless networks also reveals how market institutions naturally arise, as the resale model, having proven difficult to effectively implement via regulation in fixed or wireless networks, now flourishes in mobile phone markets with such national "carriers" as TracFone or Virgin Mobile.

   Of direct significance for local telephone regulation is that competing facilities are in place. Cable TV systems pass about ninety-nine percent of U.S. households (10) and can economically supply either circuit-switched or Voice over Internet Protocol ("VoIP") telephony. (11) In addition to this head-to-head fixed line rivalry, plain old telephone service ("POTS") faces competition from at least four national wireless networks...