Are Local Telephone Monopolies Unnatural?:
Subadditivity, Costs and Deregulation of Local Telephone Markets
Wesley W. Wilson, University of Oregon
Abstract
In early 1996, Congress passed the Telecommunications Act of 1996. An important objective of this
legislation is to establish a procompetitive and deregulatory national policy framework in the telecommunications
industry. In establishing a procompetitive environment, this legislation opens local telecommunications
monopolies to competition by removing legal and regulatory barriers and reducing economic impediments
to entry. Prospective entrants, e.g., inter-exchange carriers (IXCs), competitive access providers (CAPs)
and cable television companies welcome the new implementation and have had moderate success in that the
Supreme Court recently stayed the implementation of opening local telephone markets.
An important premise for introducing competition into local telephone markets is that these markets are not
(or no longer) natural monopolies. However, empirical evidence pertaining to the natural monopoly
issue is far from being conclusive. Some previous studies (Evans and Heckman, 1983 and 1984 and Shin Ying,
1992) found evidence that the costs of pre-divestiture AT & T and those of major post-divestiture LECs
are not subadditive, concluding that the pre-divestiture Bell system and the post-divestiture LECs are not
natural monopolies. Using different techniques, however, other studies (Charnes, Cooper and Suyoshi, 1988 and
Roller, 1990a and 1900b) found that the pre-divestiture Bell data are consistent with a natural monopoly.
In our recent study (Wilson and Zhou, 1997), we found that findings pertaining to scale are dramatically
affected by the treatment of unobserved firm heterogeneity. When we control for unobserved heterogeneity
we find dramatic scale effects, but when we do not use such controls we find constant returns. Considering
the lack of consensual empirical evidence and the sensitivity of results to different specifications,
we reexamine the subadditivity issue in this paper and evaluate the effects of different market structures
on costs.
We update the data we employ in our recent study, estimate a cost function for LECs controlling and not
controlling for unobserved heterogeneity. We then conduct our subadditivity tests and simulations using both
specifications and compare the results. We find that when we control for unobserved heterogeneity we find
subadditive costs, while when we do not control for heterogeneity we find costs are not subadditive.
We also simulate industry costs with a varying number of firms and find that industry costs are much higher with the
introduction of additional firms.
Our findings have strong policy implications. The subadditive costs of LECs we find suggests that it may be premature
to subject LECs to competitive entry. Should regulated incumbent local exchange carriers
be natural monopolies, forcing them to open their markets for competitive entry may result in undue
competition and efficiency loss.
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