In 1998, the U.S. government began antitrust litigation against Microsoft Corporation. The government's principle argument is that Microsoft is attempting to monopolize the personal computer operating system and many of its applications through its Windows software. The government will argue that Microsoft has unfairly bundled software such as Internet Explorer with the Windows operating system on new personal computers. In an interesting twist of logic, if successful, the government will require that Microsoft charge customers for Internet Explorer rather than giving it away for free when a new personal computer is purchased.
In this unit we will look at the history of antitrust legislation and the legal ability of the government to take action. This will be followed by a historical look at how the government has regulated the telecommunications industry. The telecommunications industry is an excellent example of the rapidly changing nature of government regulation. New technology has required the government to adopt regulation to the shifting competitive landscape.
The two main government agencies that enforce antitrust legislation are the Federal Trade Commission and the Department of Justice. A "trust" typically refers to an attempt by a company to engage in horizontal mergers to monopolize or organize a strongly dominant share of an industry. Horizontal mergers take place within an industry. For example, near the turn of the twentieth century, John Rockefeller used his Standard Oil Company to acquire controlling shares of other oil companies. The goal of Rockefeller was to coordinate the majority of gasoline and oil sold in the United States and even in other parts of the world. Rockefeller could act as a monopolist, preventing the different petroleum companies from price competition. More recently, the proposed merger of Office Depot and Staples, both major sellers of office products, was blocked due to the fear that it would concentrate too much commerce.
Vertical mergers involve the combination of companies that sell complementary goods and seldom does the government take action to prevent this type of merger activity. An example of a vertical merger is the recent activities of AT&T. AT&T provides long-distance telephone service and would like to enter the local telephone service market. To facilitate this endeavor, AT&T acquired TCI, a cable television provider. AT&T will be able to use TCI's cable hookups in residential homes to provide both local and long-distance telephone service to consumers. In addition, AT&T took a large stake in AtHome, a company that provides services using cable modems to residential customers. Services include, television, movies, local and long-distance service through AT&T and Internet access. When a customer goes onto the Internet, where is their first or default stop? AtHome purchased Excite, an Internet portal. When a customer subscribes to AtHome's service and goes onto the Web, the first Web site they will visit will be Excite. Through vertical mergers, AT&T is attempting to construct an empire that offers all audio, video, and Internet telecommunication services that a residence would require.
Antitrust History
In the Late 1800s, populist agitation on American farms was directed by farmers who saw grain prices falling, but prices of farm supplies holding steady. Farm supplies were controlled by trusts that limited competition and prevented prices of farm supplies from falling. John Sherman was a Republican Senator from Ohio and presidential hopeful who responded with a declaration that "trusts smacked of kingly prerogative. A nation that would not submit to an emperor should not submit to an autocrat of trade." In 1890 the Sherman Act was enacted to deal with established trusts and was used in 1911 to break up the Standard Oil trust. In 1914 the Clayton Act was passed in order to deal with proposed mergers between companies that would create a firm with too much market power, promote monopoly behavior and limit competition.
Until the later part of the twentieth century, the government and the courts vigorously went after firms that gained or were attempting to gain too much clout within a market. For example, in 1966 the Supreme Court ruled in favor of the government when it blocked the acquisition of Blatz Brewing Company by Pabst Brewing. Unless one spent their beer-sipping days in a mid-Atlantic U.S. state (e.g. Pabst was a favorite beer at Baltimore Oriole baseball games played in Baltimore), these are not beers that are found in the coolers of many picnics. The government was worried about Pabst gaining increased market share even though the combined firm would remain a minor player in the beer industry.
Attitudes began to change in the 1970s as the attention of regulators and economists shifted from the static nature of markets to the dynamic changes that were taking place in the economy. Just because a merger resulted in a larger company, markets were often growing robustly, new firms could enter and competition could increase even when merger activity was present. Attention also shifted to the positive benefits of mergers on lowering costs and increased efficiency that could be realized when similar firms combined their activities. Merging firms would combine suppliers, shipping, management and possibly production to lower costs. Greater productive efficiency, lower costs and perhaps lower prices for customers could outweigh the negatives of losing a competing firm in the industry. Furthermore, the government realized that the rising globalization of the economy increased foreign competition and limited the ability of domestic firms to control markets and prices.
The pace of technological change also sped up in the 1970s. From the 1950s until the early 1980s, the computer industry was basically IBM, as the company's mainframes provided the great majority of computer services. In the 1980s, the government finally dropped its decade-long antitrust case against IBM as new competitors in the personal computer market had already severely eroded IBM's dominance of industry.
The Telecommunications Industry: A Historical Overview
Historically, the U.S. telephone industry has seen both intense competition and a single, monopoly provider. The early U.S. telephone landscape was competitive and by 1890 there were three telephone companies serving the rapidly growing U.S. market. In the larger cities such as New York where all three companies offered competing services, each company developed its telephone system separately and did not interconnect with the other two. As a result, in heavily populated areas of the city, telephone wires and poles dominated the urban landscape, as each firm strung its own wires into the homes and businesses of customers. Sometimes, the wires were thick enough to block out the sunlight on the streets below, offering a canopy of shade similar to a row of trees. With three possible sources for incoming telephone calls, a fully connected customer was required to have three functional telephones, one for each of the service providers.
The eventual king of the U.S. telecommunications industry originated in 1885 when AT&T (American Telegraph and Telephone) was formed as the long distance subsidiary of American Bell Telephone Company. In 1899, AT&T became the parent of the Bell telephone system.
Until 1912, long distance calls required a repeater. Because of the limited technology present at that time, voice conversations over telephone wires would fade in volume as the distance between two parties increased. Long distance customers were not able to communicate directly with each other and instead woman repeaters employed by the telephone companies were used as an intermediary between two conversing customers. Just as modern conversations between two individuals that speak a different language require a translator, a businessman located in New York at the turn of the twentieth century would speak to a repeater would then relay his words to his counterpart in Boston. But in 1912, improved vacuum tubes had enough power to amplify signals over telephone wires and the repeaters lost their jobs to this technological innovation.
By 1913, AT&T had become the dominant firm in the U.S. telecommunications industry and the government began its first attempt to diversify AT&T’s power by breaking it up. By this time, AT&T was grabbing an increasing part of the market, leaving scraps and eventual bankruptcy for the other independent telephone companies. Customers preferred service with AT&T because most other residential and business telephones were part of the same network. However, the Kingsbury Commitment (1913) voluntarily allowed for AT&T to remain intact. In the agreement, AT&T agreed to interconnect the independent telephone companies into the AT&T network.
For the most of U.S. telecommunications history, AT&T monopolized the great majority of local and long-distance telephone access and service with the full blessing of the federal and state governments. AT&T acted and was regulated as a natural monopoly. The 1922 Graham Act provided a legal recognition that AT&T was a natural monopoly in the same class as water services and electricity. A natural monopoly occurs when it is economically feasible for one firm to serve the entire market. In this case, AT&T served the majority of the U.S. telecommunications market. As a regulated monopolist, prices that AT&T could charge were set by state Public Utilities Commissions (PUCs) and entry of new competition was prohibited.
The Telecommunications Industry: Universal Service
The major regulatory agency in charge of the telecommunication industry was formed by the 1934 Communications Act that created the Federal Communications Commission (FCC). One of the early mandates that the FCC imposed that still has important consequences for the modern environment of increased competition is known as "universal service." The concept of universal service required AT&T to include all potential customers into the telephone network. While it may seem desirable for AT&T to maximize revenues and thus customers, like most businesses the goal of AT&T is to maximize profits. Profit maximization requires that both revenues and costs are taken into consideration in the business decision.
For obvious reasons, urban customers are easier for a telephone company to serve with fixed-line wires than are rural customers. High population densities allows for economies of scale in providing service to customers, while in rural where the cost per customer of providing service rises substantially. Left to their own business decision-making, telephone companies would have little incentive to offer wire line service to rural customers. Universal service requires the telephone monopoly to provide service to rural customers regardless of the high fixed cost of hooking those customers into the telephone network.
Since rural customers are charged the same rates for telephone service as their urban counterparts, rural customers receive a subsidized service where rates do not cover costs of installation and maintenance. The subsidy is generated by overcharging business customers for telephony services. The low price of rural telephone services represents implicit subsidies. The dollars generated to subsidize rural telephone subscribers comes from disproportionately high prices for business lines or for vertical services such as call waiting, caller ID, and from the access charges that local exchange carriers collect from long-distance companies (interexchage carriers) for originating and terminating long-distance calls. AT&T (and later the Baby Bells) were (and still are) ordered by regulators to charge business customers a rate above cost and normal profit in order to create the surplus funds needed to meet the service requirements of rural customers.
Today, the Universal service requirement opens a door for new competitors such as Worldcomm and Qwest (in the United States) that are not subject to regulation and meeting the requirements of universal service. A new competitor, known to the Baby Bells as a CLEC (competitive local exchange carrier), can choose the markets where they want to offer service. Since they do not need to charge commercial customers a rate that subsidizes rural customers, the CLECs can undercut the prices of the regulated Bells and obtain a share of the urban market. For the same reason, new competitors will focus on urban residential customers where the firm can take advantage of economies of scale.
The Telecommunications Industry: Consent Decree
By the early 1950s, AT&T was looking to expand to markets beyond its telephone monopoly and into markets such as computers, washing machines and other products not directly related to telephone service. If allowed to enter these markets, AT&T would have an advantage over existing producers. Since AT&T had a steady flow of revenues from its protected telephone monopoly, it could use part of its profits to subsidize production of other, non-telephony goods. Therefore, AT&T could easily undercut the prices of its competitors and perhaps monopolize these industries as well. Lawmakers recognized the conflicts present if a regulated monopolist is allowed to expand into competitive markets and undertook the first in a series of actions to break up AT&T and end its telephone monopoly.
In the 1956 Consent Decree, AT&T agreed to limit activities to the common carrier business and to make its Bell Labs patents available to other firms. In return, AT&T was allowed to remain intact.
By the 1970s, new technologies were allowing for telephone connections outside the wire-line system. Microwave Communications Inc. (MCI) used microwave radio links to connect private telephone lines. Primarily targeting businesses with lower telephone rates, MCI presented competition to AT&T in long distance telephone connections.
AT&T’s monopoly began to disintegrate in the court system as MCI challenged its monopoly status with lawsuits MCI1 and MCI2 to allow interconnection into the AT&T network and competition in the long-distance market. Federal courts ruled in favor of MCI and the Justice Department began a long process of dissolving AT&T’s monopoly and allowing for competition in the telecommunications market.
By the 1980s, AT&T was suffering from too many years as a monopoly, protected from meaningful competition. Its products were becoming outdated and unable to meet the demands of new markets. For example, competitors such as Canada’s Northern Telecomm were building digital telephone systems that allowed computers to communicate with each other over telephone lines more effectively than AT&T’s dated analog equipment. Meanwhile, AT&T Chairman Robert Allen presented AT&T’s approach to the convergence of the computer and telephone by holding a telephone next to a computer during a splashy news conference.
Advances in technology such as the computer, satellite and cellular communication, fax and rapid shipping of parcels and letters by companies such as Federal Express offered companies new options to communicate and to transfer information. A constant stream of innovation opened new markets, making higher technology a household word and increased demands by the business sector for deregulation and open markets in telecommunications.
Finally in 1984, after ten years of fighting the Justice Department inch by inch, AT&T realized that it was better to settle with the government rather than risk losing in the courts and letting the government to decide how the monopoly would be broken up. The Modification of Final Judgment allowed AT&T to remain in the long-distance business and retain its Western Electric (producer of telephones, switches and other equipment, that later would be split off into Lucent) and Bell Labs (its research division) subsidiaries. AT&T gave up its control of the local loop. Seven regional Baby Bells were created to handle local calls. The Baby Bells were in charge of offering universal local service, adding new connections and maintaining the local loop infrastructure.
In what has amounted to one of the poorest corporate acquisitions in history, Mr. Allen undertook a hostile takeover of a company named National Cash Register (NCR) in 1991. NCR had diversified into the computer industry and AT&T saw the company as a way to enter the rapidly growing personal computer market. Unfortunately, NCR was not highly regarded in the PC business and buyers preferred the technologically superior products of companies like Compaq and Dell. Four years later, when NCR was spun off from the parent AT&T, it is estimated that the computer subsidiary had a net loss of $10 billion for AT&T.
The Telecommunications Industry: Telecommunications Deregulation
The Telecommunications Industry: 8th Circuit and Supreme CourtThe Modification of Final Judgment (MFJ) placed the telecommunications industry and national telecommunications policy under the control of U.S. District Court Judge Harold Greene. The MFJ lacked a sunset provision to fix its duration and it stayed in effect for thirteen years. Finally, in 1996 legislation was enacted that replaced Judge Greene with a national telecommunications policy.
Landmark legislation was enacted in 1996 that promoted competition in all parts of the telecommunications system, especially in the local loop. The Telecommunication Act was designed to encourage the Baby Bells to grant access to the local loop (also know as the last mile). In return, the Baby Bells would be allowed to offer a complete range of telecommunications services, including global long-distance.
The Telecommunications Act did not deregulate the telecommunications industry; rather control was placed in the hands of the Federal Communications Commission (FCC). While it tried to formulate a telecommunications policy, the Telecommunications Act only specified the broad strokes. The details were left to the FCC which has been interpreting and implementing many aspects of the Act.
One of the primary goals of Congress in passing the Telecommunications Act was to allow for competition in the local loop. At the present time access to local loop is controlled by the Baby Bells unless a competitor has actually gone in and placed their own wires and connectors in a business or home. This situation is unlikely to change in the near future for residential customers, as it is prohibitively expensive to enter a home and add physical wiring to what already exists with the present telephone jacks.
When undertaking reform, Congress has stipulated that the RBOCs must offer any services that they sell to customers at a resale discount to competitors at a discount of 20 percent to 30 percent if the services are bundled and at a 50 percent discount if the competitors choose access as unbundled where CLECs buy access to the customer’s phone jacks and offer their own services.
By granting widespread access to the local loop, the Bells hoped that the Telecommunications Act would open the doors to the long distance and other previously restricted markets. In the new environment, the Baby Bells could open up the local loop in several potential ways.
They can allow free access to competitors. In this case competitors can use their own switching equipment to connect customers homes and businesses to the competitors network. For example, if AT&T desires to combine local with existing long-distance services, they can use their own system of fiber optic cable, switches and other equipment to connect directly to the existing twisted pair copper wiring (that connects a telephone outlet to the telephone network) of a home or business.
The Baby Bells can sell local loop access to competitors. The reselling of access may take on many different permutations. The simplest "unbundled" service would involve the leasing of lines to competitors. Competitors would have to provide their own switches to connect the home of business to their telephony infrastructure. For a higher fee, competitors could also lease use of the switches of the Baby Bells and a basic group of services such as operator assistance and 911 dialing. A higher level of "bundled" services may include options such as call forwarding and call waiting. By leasing bundled services, a competitor can offer similar services as the local Baby Bell without having to purchase redundant equipment.
Although the Telecommunications Act gave guidelines for the unbundling of network elements in the local loop, it provided no steps for the Baby Bells to follow to enter the long distance market. Lacking a clear objective, the Bells have stonewalled to protect their major asset and revenue source – the control of the local loop. Since the Telecommunications Act was passed, the Bells have been very active in litigation against the guidelines to permit local access competition. For example, the rates set by the FCC for the interconnection of new carriers into the local loop have been challenged in the courts.
Currently, when a customer makes a long distance telephone call, the long distance carrier (e.g. AT&T or MCI) pays a tariff of 2.8c to the Bell that offers the local loop where the call originates and another 2.8c connection fee to the local loop Bell where the call is connected, or 5.6c total. At the present time, on average 40% of long distance revenues earned by the long distance carriers is paid to the local carriers. The FCC has decided that the national rate should be lowered to a total of 3.2c, or 1.6c for call origination and 1.6c for call connection. The regional Bells (RBOCs) make the argument that this rate should not be set by the FCC but by state Public Utility Commissions.
The RBOCs also argue that they are being excluded from offering long distance services simply because they are RBOCs. Frustration has arisen among policy makers who perceive some of these RBOC initiated lawsuits as an attempt to block the opening up of the local loop.
The Telecommunications Act stipulated that the Federal Communications Commission would become the primary regulator of the telecommunications industry. The goal was to create a national governing body for the industry rather that the state-by-state Public Utilities Commission's (PUC) that acted as the primary regulator. This condition was immediately contested in the courts by the Baby Bells who preferred their well-established relationships with the PUCs in the states they serve. An early legal decision went in favor of the RBOCs when the Eighth District Court of Appeals ruled that the PUCs would remain as the primary governing body of the telecommunications industry under their individual jurisdictions. However, in January 1999, the Supreme Court overturned the appeals court decision and affirmed the Telecommunication Act by ruling that the FCC was in charge.
The Telecommunications Industry: Economic Issues
When adding together the revenues earned from different telecommunications services, the annual revenues for the U.S. telecommunications market alone equals about $200 billion a year. The growth rate for basic telephony services yields an annual revenue growth rate for the RBOCs of 5 percent to 7 percent. Not only are the RBOCs continually adding new customers, thanks to better programmed and engineered switching equipment, they are offering high value-added services to customers such as automatic call-forwarding. Revenues in the wireless-cellular area are growing roughly at a 10% annual rate and for the telecommunications markets as an entirety; revenues are rising at a 8% annual pace.
For the local-access providers, selling bundled services to customers is the driver of profits. For example, in the mid-1990s, it cost Pacific Bell about $25 to provide service to an average residential customer in California. However, the basic residential service rate set by the California Public Utilities Commission equaled $11.25. To make a profit on residential lines, Pacific Bell earns additional revenues by selling services such as caller-ID and Internet access.
Per customer, the RBOCs find that businesses offer the greatest returns. In 1997, the average large business customer of BellSouth spent $1,248 on local switched services, $2,113 on InterLATA long distance calls and $232 on IntraLATA tariff calls. Not surprisingly, the majority of competition faced by the RBOCs is in the business telephony sector.
One of the critical issues facing modern telecommunications is the merger of traditional telephony with the Internet. Companies such as Qwest Communications and Sprint are building communications networks that are designed to send information, including voice telephone calls and video through packets. At the present time, when we browse Internet Web sites, our PC receives information in small packets. These packets are assembled by our Web browser into a coherent Web page. As most home Web surfers are aware, transmission speed are slow and limited by our PC modems. Voice and video are impossible unless the users are willing to put up with noticeable pauses during spoken words and video scenes.
The major advantage of sending information through the Internet in the form of packets is efficiency. A telephone call requires a dedicated line or circuit. However, during a conversation, we are only using a small part of the line capacity and that is when we are actually speaking. A packet transmission system just uses the capacity that we individually require. In this type of system, when you are speaking on the telephone, you sentences are broken up into small packets, sent through the Internet and reassembled at the other end for the listener to hear. When you lips are idling, your use of the Internet stops as well. In this method, a two-way conversation uses just a fractional part of the Internet system designed by our Internet service provider (ISP). A major advantage is that the ISP can charge us for our use (amount of packets that we send or receive) rather that the duration of a telephone call.
The Telecommunications Industry Special Focus: AT&T merges with TCI
If there is a seminal event in modern telecommunications, it is the acquisition of TCI by AT&T announced on June 23, 1998. The equivalent of a major telecommunications earthquake, the merger will greatly accelerate mergers, cooperative efforts and competition in the telecommunications industry.
At the present time, the majority of AT&T’s revenues are earned from long-distance calling where they pay part of their revenues (roughly 40c for every dollar earned) to the RBOCs as a tariff. Certainly, AT&T would like to complete the entire call, from origination to connection and keep the total dollar for itself. As we have discussed, for a long distance carrier such as AT&T to gain access to the local loop they either have to lease access from the RBOCs or install their own lines to reach residential customers (an extremely expensive option).
The cable companies do have an alternative in place to offer residential customers telephony services by going through the coaxial wires or cable outlets found in the majority of homes (electric companies are also considering using existing electrical wires and outlets to offer telephony services).
Since 1996, AT&T has paid the RBOCs and other local providers such as GTE over $4 billion attempting to directly gain access to the local residential market. Revenues for local service reached only about $65 million during that time. Seeing little return for its investment, AT&T decided that going through TCI’s coaxial cable was a better route in the long run than leasing lines from the RBOCs and GTE.
Beginning in 1998, we can expect AT&T to move in stages. The first step that AT&T will take is the joint marketing of cable and long-distance services, perhaps offering discounts on combined services. AT&T will also offer enhancements in its Internet services by offering customers high-speed Internet access using cable modems. The third step of the process should be widely marketed by the year 2001 or 2002 when AT&T bundles all of its services together. At that time the customer will be able to order local and long distance telephony services, Internet access, cable television, movies and music all through the cable outlet present in most homes.
The present telephone system is symmetrical in that you can send as easily as you can receive. In contrast, most of the nation’s existing cable system is one-way and can only receive information. For AT&T to offer enhanced services, the majority of the cable infrastructure must be upgraded to work two-way. Presently, Only 15 to 20 percent of the nation's cable systems can handle the two-way traffic needed for telephone and Internet access, and only about 10 percent of TCI's systems are two-way. A one-way system only receives a signal, such as cable television broadcasting, a two-way system is required in order for the customer to send information into the system such as what Web site they would like to visit or to talk with a friend on the telephone. Turning one-way cable-TV lines into the two-way connections required for telephone, video on demand and Internet usage will cost billions of dollars. Ultimately, TCI's network of cable systems has the potential to reach inside one-third of all U.S. homes.
Overall, the merger is good for competition in both the local and long-distance telephony markets. The Telecommunications Act of 1996 prevents the Bell companies from providing long-distance service in their home territories until they prove they have opened their markets to local competition. The AT&T move can accelerate the move by the RBOCs into long-distance services and as we will discuss in Chapter 2, the RBOCs have their own plans for combined telephony, Internet and television-entertainment customer packages.
Copyright © 1999, Jay Kaplan
All rights reserved
Last updated July 1999