The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective. \u27 Conference held at the University of Pennsylvania Law School on April 18-19, 2008.
The antitrust law books promise competition from breaking up the monopoly firm in a Sherman Act case remedy. Not in this case; the question is what  kind  of oligopoly

MacAvoy, Paul W.

English

Indiana University Bloomington Maurer School of Law

Federal Communications LawJournalVolume 61 | Issue 1 Article 512-2008An Oligopoly Analysis of AT&T's Performance inthe Wireline Long- Distance Markets AfterDivestiturePaul W. MacAvoyYale School of ManagementFollow this and additional works at: http://www.repository.law.indiana.edu/fcljPart of the Administrative Law Commons, Antitrust and Trade Regulation Commons,Communications Law Commons, and the Legislation CommonsThis Symposium is brought to you for free and open access by the LawSchool Journals at Digital Repository @ Maurer Law. It has been acceptedfor inclusion in Federal Communications Law Journal by an authorizedadministrator of Digital Repository @ Maurer Law. For more information,please contact wattn@indiana.edu.Recommended CitationMacAvoy, Paul W. (2008) "An Oligopoly Analysis of AT&T's Performance in the Wireline Long- Distance Markets After Divestiture,"Federal Communications Law Journal: Vol. 61: Iss. 1, Article 5.Available at: http://www.repository.law.indiana.edu/fclj/vol61/iss1/5An Oligopoly Analysis of AT&T'sPerformance in the Wireline Long-Distance Markets After DivestiturePaul W. MacAvoy*Having been present at the creation of "divestiture," as the nextwitness for the defense scheduled to be called before the court, the dayafter the surprise settlement, and therefore never heard, I had a seat at thetable to listen to what was to be forthcoming. It was evident to me thatAT&T management expected to become the dominant long-distance (LD)wireline service provider in nationwide business and residential markets,free of price controls of the FCC. The Antitrust Division never said that LDdivestiture from the local exchange companies was expected to result ineffective LD competition. Instead, the divestiture process plus open entryin LD markets was meant to create as many LD carriers operating as faraway from regulation as possible in numerous duplicative carriernetworks.' But the Antitrust Division made no connection betweennumbers of networks and competition among LD service suppliers.The antitrust court, Judge Greene's district court, had plans to managethe process of creating duplicative national networks. The local exchangecompanies were forced to build out their interconnection nodes to provideparity for all old and new LD carriers in picking up and delivering calls. In* Williams Brothers Professor of Management Studies, Emeritus and former Dean,Yale School of Management. Member of the Counsel of Economic Advisors in the FordAdministration.1. See Paul W. MacAvoy & Kenneth Robinson, Winning by Losing: The AT&TSettlement and Its Impact on Telecommunications, I YALE J. ON REG. 1 (1983).FEDERAL COMMUNICATIONS LAW JOURNALthe transition period before parity was achieved, beginning in 1984, theregulated charges for interconnection favored the other carriers, and thesenew carriers then expanded relative to AT&T. AT&T lost a third of its 90%plus share of call revenues, in both national residence and business servicemarkets. Accounting for revenue shares of AT&T, and the entrants MCIand Sprint, with then-comparable national service offerings, theHerfindahl-Hirschman Index (HHI) fell from close to 0.9, indicative of amarket structure in which there were 1.1 firms, to 0.5, similar to that fortwo equally sized firms by the end of the first dozen years of the courtremedy process.2 The prices in AT&T's tariff were still subject to caps setby the FCC, because AT&T was still defined as a "dominant firm" by theFCC while MCI and Sprint were not. While the caps were seldom limiting,the FCC process allowed the three carriers to set the same prices; AT&Tsubmitted its tariff to the FCC as required and the other two followedvoluntarily.The Judge Greene court, in effect, was implementing the regulatoryreform programs of the Ford and Carter Administrations in the othernetwork industries. These programs: (a) separated ownership of the productat the entry node from transport services from that node to the exit node,and (b) regulated prices for link and node utilization where there were openentry "bottlenecks." By legislation or agency rulemaking, the gas networksor power grids were restructured into newly defined, open-entry regionalmarkets subject to price caps at key nodes. These partial deregulatorypolicies proceeded through the mid 1980s to the late 1990s changing onlyto add auction markets in place of some price controls. The Greene court'santitrust policy in the AT&T divestiture went in this direction.The AT&T revenue share from wireline services declined by 2% to5% per year from 1984 to 1991, then stabilized at 65%, which held, plus orminus 1%, until 1997.3 To lose a third of total revenue share in any of thesenetwork industries presaged a decline in price relative to the costs ofservice. In fact, both residential and business LD charges declined, but sodid the (regulated) interexchange switching charges that constituted thelargest share of LD costs. Wireline LD prices for services throughout thecountry went down, but not by as much as did marginal costs for theseservices in this fifteen year period. Price net of marginal cost, as apercentage of price,-the Lerner Index in oligopoly theory-increased onstandard plan services to an amount in excess of 60%. Even on discount2. See PAUL W. MAcAvOY, THE FAILURE OF ANTITRUST AND REGULATION TOESTABLISH CoMPETITIoN IN LONG DISTANCE TELEPHONE SERVICES 131 (1966); C.f PAUL W.MAcAvoy, THE UNSUSTAINABLE COSTS OF PARTIAL DEREGULATION (2007).3. See MAcAvoY, UNSUSTAINABLE COSTS, supra note 2.[Vol. 61AN OLIGOPOLY ANALYSISplans-contracts for service to which large numbers of residentialsubscribers were switching-these margins increased from 65% to 68%.The AT&T share of wireline revenues, which was close to two-thirds,ceased declining in the 1990s, while shares of the two other firmlyestablished carriers with national networks, MCI and Sprint, ceasedincreasing. Demand functions were negatively sloped for the two mainresidential services, standard and discount, with elasticities less than one.The high and increasing price-cost (Lerner) margins were not indicative ofcompetitive pricing; they were too high, and were increasing after marketshares stabilized. Demands for business services were highly interactive,with change in prices and service packages customized to lure largecorporate clients. These patterns of interactive prices and fast-changingservice packages did not fit those of a competitive pricing system either.If not competitive, then what? The market structure was characterizedby one large carrier and two others, each able to provide full service of anational scale, essentially that of an oligopoly. There were not enoughdifferent sources of comparable service, by construct, "two" according tothe HHI, to force price levels down to the near-zero competitive Lernermargin. There were limited price differences, mostly associated withdiscount packages for AT&T and MCI, but Sprint copied the prices inAT&T's tariff. Then the "what" question becomes, what kind of oligopoly?With tariffs at the FCC putting in place one-shot price schedules that heldfor most of a year, the "kind" or "classification" of oligopoly was Cournot,which implied that an HHI equivalent of two firms would result in a LernerIndex half of that with an LD monopoly.Consider that these pricing margins were in fact the result of aconcerted Cournot strategy; the Lerner Index would be the product ofmarket share multiplied by the "strategic factor," divided by the marketdemand elasticity. That factor, the coefficient of conjectural variation, V,determined that repetitive responses of the two smaller network serviceproviders would either complement (V = +1) or substitute (V = -1) forservice initiatives of AT&T. Complementary responses, to every change inAT&T's service offerings, produced "defined" Cournot margins.Substituting responses, in which the two followers increased service whenAT&T reduced service, renders the Lerner margin convergent to zero, thereplication of "competitive pricing." 5The changes in Lerner margins from the mid 1980s to 1997 wereneither largely positive nor negative. The second and third carriers did not4. See id.5. With the conventional profit maximizing model, for firm i, in which product levelsqi and qj are interactive, then first order conditions for Lerner "L" or price-cost margin forfirm ",' (pi-ci)/pl=[(qi/Q)(+V)]/e.Number 1]FEDERAL COMMUNICATIONS LAW JOURNALfollow in lock step to undercut AT&T, nor did they provide the expansivesupport necessary to allow AT&T to set tariff prices at monopoly levels.From year to year, the AT&T conjectural variation ranged from 0 to -0.3,values associated with setting out a strategy to disregard the responses ofthe other two providers. But the large service provider was not able tototally ignore the others over this long period of time. The Lerner margin,even though increasing, was too low-by 20 0/--and the elasticity ofdemand was not sufficiently large (negative), to validate a strategy ofmonopoly.In 1996, with passage of the Telecommunications Act, the frameworkin which AT&T set its strategic pricing changed. The last vestiges of tariffsdisappeared for the three carriers, rendering it difficult for the largestcarrier to take the lead in the continued pattern of reductions in conjecturalvariation, which were small. The merchandising practices of the companiesto stabilize Cournot turned to simplification of pricing with announcementsof "cents per minute" packages containing some featured services. Themechanics for knowing what all the major providers were doing, sufficientto practice Cournot, were still maintained by simplifying the tariff.However, there were other determinants of price formation movingagainst stable to increasing price cost margins. The rapid expansion of cellphone service, not only by the three carriers, but also by at least threeindependent service providers, provided the option for both commercialand residential customers to shift out of wireline services at prices lower orcomparable to those of discount LD service packages. The price elasticityof wireline service demands was increasing from a range of -0.7 to morethan -1.1 in the few field tests made in that period. Greater price sensitivityand difficulty in preventing shifting to other wireless service providers putpressure on the Cournot strategy.Even so, significant pressure was exerted by the FCC in implementingthe Telecommunications Act for the three wireline carriers to increaseLerner margins extensively. The new funds necessary to provide universalservice to be collected from LD service subscribers called for increasingprice-cost margins to "pass through" a universal funds "tax." However,with Cournot pricing these carriers had to absorb some percentage of thetax and would be left in too weak of a profit position to sustain services, letalone expand the long-called-for broadband access, or so they argued.This argument of the carriers on "pass through" was logically sound.A continuation of Cournot would require a 2% to 4% reduction in Lernermargins to collect a 10% universal service tax. Only a more collusivepricing arrangement would result in the larger cash flow necessary to covera 10% surcharge.[Vol. 61AN OLIGOPOLYANALYSISIn this post Telecommunications Act period, from 1997 to 2004,AT&T's Lerner margins increased from 60% to the low 90% range forstandard residential service, a rapidly declining class of service. AT&T'sLerner margins on discount plan services also increased, but by much less,on this increasing class of service. The Lerner Index estimates were inexcess of those consistent with Cournot without pass-through of theUniversal Service Fund (USF) charges levied by the FCC. There was anopportunity provided by USF recovery plans, fostered by the FCC, tojointly increase prices more collusively. That all three carriers succeeded inmore than full USF recovery from increased Lerner margins was indicatedby an FCC order limiting recovery surcharges to the required contribution.6Did AT&T, in this last stage of its existence, conspire with the FCC toset LD joint monopoly prices? Its Lerner Index values clearly resulted froma new collective strategy (i.e., a value of V>o). In most years, the estimateof conjectural variation increased to greater than 1.0, indicative of a jointstrategy to set the price level. Given a market share of 0.4 and the LernerIndex at 0.88, the conjectural variation coefficient had to exceed 1.5 formonopoly. 7 In line with the 1997-2004 data, the average V equaled 1.2 forstandard plan wireline and 0.9 for discount plans in place. In standard planservice, while that service was in decline, AT&T had prices approachingmonopoly levels. While in discount plans, where price-sensitive customersmigrated to wireless in large numbers, prices were not at those levels.In a November 2005 speech to the people of AT&T, the CEOexpressed the current condition succinctly, saying, "the old business wehad worked fine with much higher price levels" leaving out the words"standard plan," but noting that with the shift out of old business todiscount plans and wireless, "we have serious trouble given the directionprices [are] headed." He put it another way that was even moreilluminating, "our customers needed what we provided them, butcompetitive price levels made it impossible for us to make a profit with thecost structure." What the customers "needed" were "new service offeringsto create new revenue streams." 8 Broadband waited to be funded, and onlymonopoly level prices inclusive of the tax would provide those funds.In the twenty years from 1984 to 2004, the court-initiatedimplementation process was intended first to structurally separate localacquisition of calls from LD delivery, and second to add to the number of6. Federal State Joint Board on Universal Service, Report and Order and SecondFurther Notice of Proposed Rulemaking, 17 F.C.C.R. 24952, paras. 40-63 (2002).7. With the Lerner Index of 0.88 in residential service markets, demand elasticity of1.1 and market share of firm i, AT&T, equal to qilQ=0.40 then 0.88=0.40 (I+ )/1.1 and theestimated V=1.2 The monopoly value of V is the solution of S,{I+P)l which here is 1.5.8. David W. Dorman, CEO, AT&T, Corp., Speech to AT&T (Nov. 2005).Number 1]FEDERAL COMMUNICATIONS LA WJOURNALnetworks independent of AT&T. Whether this was ever expected to resultin competitive market performance is unknown. By 2004, specializedcommon carriers and wireless service providers had achieved the structuralpart, but with either Coumot oligopoly prices, or with the FCC "inspired"joint tax for monopoly pricing. At that point in time, an industry-widereversal of this structural condition took place, a merger which sent AT&Tback into providing local exchanges, and caused other local operatingcompanies to attach to the leading wireless companies. That series ofmergers reversed direction against the structural goals of the 1984 antitrustcourt and the Justice Department.This structural reversal brought the case for a divestiture antitrustremedy to an end. At least in this industry, and perhaps in others, thestructured fragmentation goal was shelved. There are at least three resultsfrom there: (1) the court's resorting in complex antitrust proceedings tosettlement between the parties does not remake market structures consistentwith the competitive model; (2) conditions of scale and scope inherent innetworks work against structural remedies seeking to set a dozen serviceproviders in markets; and (3) specific to bottleneck price controls, providea compelling incentive for introducing bundled services that make itimpossible to use price to monitor performance.In light of these current conditions, after numerous papers and bookson oligopoly and regulation, this is my last inquiry into antitrust andregulation in telecommunications. I cannot work without being able todefine markets and prices, to unravel industry performance; and that is nolonger possible. One can no longer tell what the oligopoly is doing.[Vol. 61

An Oligopoly Analysis of AT&T\u27s Performance in the Wireline Long- Distance Markets After Divestiture

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An Oligopoly Analysis of AT&T\u27s Performance in the Wireline Long- Distance Markets After Divestiture

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