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Press Release

    Comments of CSE Foundation before the Federal Communications Commission in the Matter of Merger of SBC Communications, Inc., and

    10/14/1998

    Comments of CSE Foundation before the Federal Communications Commission in the Matter of Merger of SBC Communications, Inc., and Ameritech Corporation. CC Docket No. 98-141
    BEFORE THE
    FEDERAL COMMUNICATIONS COMMISSION
    WASHINGTON, D.C. 20554

    ------------------------------
    In the Matter of )
    )
    Merger of SBC Communications, Inc., ) CC Docket No. 98-141
    )
    and )
    )
    Ameritech Corporation )
    -------------------------------

    Comments of Citizens for a Sound Economy Foundation

    Table of Contents
    Introduction
    I. The Merger Reflects Fundamental Changes in the Telecommunications Market
    II. The Merger Poses No Threat of Monopolistic Abuse
    Where do SBC and Ameritech compete?
    Would SBC and Ameritech have expanded their competition in the absence of the merger?

    Would two separate companies be more effective competitors?
    Is the merger necessary to produce the projected direct benefits?
    Is the merger necessary for the national-local strategy?
    Market dynamism mitigates market power.
    III. The Merger Could Deliver Large Consumer Benefits
    Principal benefits claimed by the companies.
    How much of these benefits will flow to consumers?
    Competitive markets.
    Regulated markets.
    The proposal to offer out-of-region residential service is credible.
    The merger creates incentives for voluntary unbundling by SBC and Ameritech.
    The merger creates a "maverick firm" in regard to unbundling.
    Even if the consumer benefits are unsure, the merger should be allowed to proceed.
    IV. Conclusion

    Introduction

    Citizens for a Sound Economy Foundation is a 501(c)3 nonprofit and educational foundation with more than 250,000 members and supporters nationwide. We take a strong interest in the SBC-Ameritech merger because we believe that all consumers are best served by a competitive, deregulated telecommunications market rather than the old system of government-enforced monopolies.

    CSE Foundation believes that consumer welfare should be the principal criterion guiding all regulatory decisions. This belief stems from a fundamental assumption, common in mainstream economic analysis, that the purpose of an economic system is to satisfy the most highly-valued desires of consumers. This gives our analysis of the proposed merger a sharp focus, as we do not believe that other miscellaneous "public interest" considerations should be permitted to outweigh consumer welfare considerations. But even if the Federal Communications Commission (Commission) is willing to sacrifice a measure of consumer welfare to advance other statutory or regulatory goals, our comments should be helpful in identifying the likely impact of this merger on consumers.

    After reviewing the SBC-Ameritech filing of July 24, 1998, as well as other relevant economic literature, we conclude that the merger enhances rather than retards consumer welfare, and thus should be permitted. In particular, we believe the evidence shows that:

    The merger reflects fundamental changes in the telecommunications market,
    The merger poses no threat of monopolistic abuse, and,
    The merger could deliver large consumer benefits.
    I. THE MERGER REFLECTS FUNDAMENTAL CHANGES IN THE TELECOMMUNICATIONS MARKET

    Fundamental changes in the international economy, along with changes in the nature of work and personal lifestyles, are leading consumers of all types to demand new and improved services from telecommunications companies.

    "Globalization" has now become a buzzword in policy and business circles. Beneath the hype are important realities that telecommunications companies and regulators ignore at their own peril. As people conduct a greater portion of their business on an international (or even national) scale, they have a greater need for voice, data, and video communications that connect them with the people with whom they do business. In addition, the ubiquity of business travel means that employees of businesses with national or global reach have a greater need to keep in touch with both their families and their home office when they are on the road. These factors increase consumers’ desire for high-quality, easy-to-use, seamless telecommunications services.

    Another factor altering the telecommunications marketplace is a change in the nature of work itself.1 Numerous commentators have recognized the emergence of a "post-industrial" economy in which human brainpower replaces a great deal of physical labor.2 People whose primary work deals with ideas, formulas, words, and symbols need to be able to ship their product and works-in-progress to others; this need has contributed to an explosion of business demand for bandwidth to handle data and video transmission.

    The rise of "mind work" has also increased the demand for many types of telecommunications services because mind work lends itself much more readily to telecommuting and home-based work. Whereas physical labor usually ties workers to a particular location, much mind work can be performed anywhere. Whether they are motivated by a desire to stay home and care for family members, to live in a more pleasant location, or simply to avoid a grueling daily commute, employees, entrepreneurs, and contractors alike can now work outside of "the office" all or part of the time.

    For these reasons, distinctions based on consumer location are breaking down. Territorial monopolies for local phone service are an impediment to serving multi-location customers who want to contract with one provider for all of their telecommunications needs. The traditional distinction between "business" and "residential" consumers also makes little sense in an era where mind work in the home is common.

    These economic changes suggest that there is a significant need for telecommunications companies that can offer a combination of voice, data, and video services, anywhere that mind workers are likely to be. Therefore, one successful business strategy would combine a wide scope of services with national or international reach.

    This approach is at odds with the structure of many aspects of the current telecommunications market. Pre-1996 regulation balkanized the marketplace by product line, preventing the local Bell companies from offering long-distance service and preserving telephone and cable television as separate markets. (Even the provisions of the 1996 Telecommunications Act temporarily preserve some aspects of this balkanization in the name of preventing monopolistic abuses by the local telephone companies.) Pre-1996 regulation also balkanized the industry geographically, often preventing multi-location customers from contracting with a single firm for all of their local telephone service. And to this day, regulation still fragments the industry by consumer segment, enforcing an artificial distinction between "residential" and "business" consumers in an attempt to funnel hidden subsidies to the former from the latter.3

    In this context, the SBC-Ameritech merger and associated business plan represent a clear attempt to respond to consumers’ new desires in the contemporary telecommunications market.4 No doubt, those that have an interest in the preservation of the old, heavily regulated, and artificially fragmented market will fight the merger. CSE Foundation believes that the Commission should brush aside such self-interested criticisms and permit the merger to proceed.

    II. THE MERGER POSES NO THREAT OF MONOPOLISTIC ABUSE

    This merger involves virtually no downside risk for consumers. With a few exceptions that will be dealt with through divestiture, SBC and Ameritech do not compete in each other’s service territories and have no plans to do so. There is no evidence that they could achieve the same efficiencies as independent companies, and there is plausible evidence that the merged firm will be a more effective competitor. Finally, even if the merger somehow created a degree of market power, the inherent dynamism of the telecommunications market protects consumers from long-run harm.

    Where do SBC and Ameritech compete?

    The St. Louis and Chicago wireless markets are the only places where SBC and Ameritech compete substantially.5 They plan to divest one of each of the overlapping licenses to a third party, so there will be no reduction in the number of actual, independent competitors in these markets.

    Would SBC and Ameritech have expanded their competition in the absence of the merger?

    In previous merger decisions, the Commission noted five elements must be satisfied to demonstrate that two companies are actual potential competitors:

    The market in question is highly concentrated.
    Few other potential entrants are "equivalent" to the company that proposes entering the market through the merger.
    The company entering the market by merger would have entered on its own but for the merger.
    That company had other feasible means of entry.
    The alternative means of entry had a substantial likelihood of succeeding and deconcentrating the market.6
    Of the markets under consideration, only one – the market for local exchange service – is clearly concentrated. While the long-distance market is dominated by three large carriers – AT&T, MCI, and Sprint – there is also a large fringe of resellers, and competition is vigorous.7 The market for data transmission is even less concentrated when one considers the number of substantial competitors that haul data on their own networks, in addition to the long-distance phone companies. The wireless market is now open to a large number of competitors, in part due to the auction of new PCS frequencies.

    It is reasonable to assume that only a limited number of companies possess the abilities, personnel, brand name recognition, and know-how to compete in local telephone service. Following the Commission’s analysis in Pacific Telesis-SBC, we can safely count the other Bell operating companies, AT&T/TCI, Sprint, MCI, LDDS, Cable & Wireless, and Time Warner among the actual potential competitors in the local markets of SBC and Ameritech.8

    Some might be tempted to severely limit the list of actual potential competitors, based on a narrow reading of the Commission’s analysis in the NYNEX-Bell Atlantic merger. In NYNEX-Bell Atlantic, the principal markets of concern were New York City and northern New Jersey – two large markets on the border between the two companies. In that case, the Commission identified five actual potential competitors who already possessed not just expertise, but also facilities and significant brand-name recognition in these markets: Bell Atlantic, NYNEX, Sprint, AT&T, and MCI. Significant movement of people between these two markets, combined with the potential for broadcast media advertisements to reach both markets simultaneously, made NYNEX and Bell Atlantic plausible potential competitors. However, New York City-New Jersey is a unique market. The only possibly similar market area involved in the instant merger is St. Louis and East St. Louis, but it is quite a stretch of the imagination to view these markets as comparable to New York City-New Jersey.

    Even if one chooses to view these markets as analogous, geography suggests several additional potential competitors that were not present in NYNEX-Bell Atlantic. The service territories of two other regional Bells – BellSouth and US WEST – border both Illinois and Missouri. Due to their proximity, these companies have just as good a claim to be potential entrants in Illinois as does SBC, and they have just as good a claim to be potential entrants in Missouri as does Ameritech. As local exchange carriers, both companies possess a set of advantages that could make them credible competitors.

    Finally, even if the Commission decides that the SBC-Ameritech merger significantly increases concentration in local exchange service, there is no evidence that either company plans to enter the other’s territory. SBC explored the possibility of offering local telephone service outside of its region, but market trials proved disappointing, and the company decided to focus its attention elsewhere.9 Ameritech tried selling local service bundled with cellular service in St. Louis, but has had little success and put the project on hold.10 Since the companies have no plans to compete with each other in local service and perceive no effective means of doing so, the merger does not eliminate an actual potential competitor in either’s territory.

    Would two separate companies be more effective competitors?

    Analysis of this merger is complicated by the fact that SBC and Ameritech propose not just to merge, but also to expand into 30 additional markets to become a national provider of local, long-distance, and data services. Fortunately, the Applicants provided a list of prospective benefits that they expect to accrue from the merger, separate from the national-local strategy. Thus, it is possible to ask whether they could, as separate companies, achieve the benefits attributed directly to the merger, and then also ask whether either would pursue the national-local strategy in the absence of the merger.

    Is the merger necessary to produce the projected direct benefits?

    The Applicants list a large number of expected cost savings and increased sales opportunities. The principal sources of these savings are economies of scale and scope, and wider diffusion of best practices and other knowledge across the organization.

    In theory, two separate companies could enjoy many of the economies of scale and scope that the merger attempts to achieve. They could do so by hiring each other to perform certain functions where economies of scale and scope are present, or by contracting out to independent service firms who would sign up enough businesses as clients to take full advantage of any economies of scale or scope. Indeed, the move toward such market-like arrangements is growing both within and between companies.11

    However, there are limits to the extent to which firms can contract with outsiders to supply various services. To the extent that the services require transaction-specific investments, contracting in advance over all contingencies may become too costly, and integration through a merger may provide a superior method of governing the transactions.12 In addition, the quality of services as well as the ease of contract administration may vary depending on whether the service provider shares the same "corporate culture" as the purchaser. Corporate culture helps to define the boundaries between permissible and impermissible behavior, and it also conveys difficult-to-articulate knowledge about the needs of internal customers.13 For these reasons, service provision by internal units may involve higher quality and lower communication and transaction costs. It then follows that a merger plausibly offers the most efficient way that SBC and Ameritech can capture economies of scale and scope in many internal functions.

    Diffusion of best practices and other significant knowledge may also be best accomplished through a merger. The reason is that knowledge possess some unique attributes that make it difficult to sell across company boundaries. Knowledge is subject to a well-known paradox: a buyer has difficulty evaluating what a piece of knowledge is worth until he knows what it is, but once the seller shows the buyer the knowledge, the buyer now has access to it without having paid for it. Separate firms could write contracts that prevent the buyer from using the knowledge until he has paid, but if such contracts are costly to write or enforce, it may be less expensive for the two firms to merge, so that the knowledge is kept inside the boundaries of the same organization.14 In addition, transfers of knowledge across organizations are often difficult because people in different organizations use different "mental models" to understand the markets and opportunities they face.15 When dealing with knowledge transactions, people in one firm may actually have trouble understanding what people in another firm are asking for or telling them.16 Over time, the people working for two merged firms can develop similar mental models and corporate cultures, lowering the cost of communication.

    Is the merger necessary for the national-local strategy?

    Prior to the proposed merger, neither SBC nor Ameritech planned anything like the proposed national-local strategy. On the contrary, each engaged in a few trial efforts at selling local service outside their service areas and quickly abandoned the idea.17

    It appears that a crucial ingredient in making the strategy succeed is a large base of multi-location customers in the home territory, plus rapid entry into numerous markets outside the home territory. In their combined home territories, SBC and Ameritech have more large, multi-location customers that either has individually. SBC already serves 11 of the nation’s largest telecommunications markets, and Ameritech serves nine, so that the merged company need only expand into 30 additional cities to cover the 50 largest metropolitan statistical areas in the country. Thus, a combined effort has a much larger chance of success, since it starts with more prospective customers and less construction of new facilities than either company would have if it attempted the national-local strategy individually.18

    The Applicants make a strong case that neither has enough experienced managerial employees to staff the proposed expansion. The companies expect to have 8,000 employees devoted to the new markets within 10 years.19 Of that number, 2,850 would be managers – a number equal to 8 percent of the combined companies’ current managerial workforce. If SBC tried the national-local strategy on its own, it would need to employ 3,515 managers in new markets (16 percent of its current managerial labor force). If Ameritech tried the national-local strategy on its own, it would need to employ 4,085 managers in new markets (36 percent of its current managerial labor force).20 Clearly, the two companies together can better handle the national expansion because their merger both reduces the number of new markets to enter and increases the pool of managers available to deploy.

    We do take issue with Applicants’ argument that the merger is necessary because neither company alone could bear the earnings dilution that the national-local strategy would entail.21 According to this view, capital markets evaluate stocks of local exchange carriers like SBC and Ameritech based primarily on earnings rather than future growth prospects. The heavy negative cash flows associated with the national-local strategy would severely depress earnings, presumably depressing stock prices and making it more difficult or expensive for a single company to attract equity capital.

    The earnings dilution argument appears to be based on a highly questionable assumption of inefficiencies in American and global capital markets. It may well be the case that financial markets currently evaluate local exchange carriers’ stocks based on earnings (and dividend flows), because regulation has historically limited these carriers’ ability to diversify into high-growth markets. However, it does not then follow that investors will continue to use the same criteria to evaluate a local exchange carrier that publicly announces a significant and credible new strategy for nationwide expansion and obtains the regulatory approvals necessary to do so. The more likely scenario is that financial market participants will incorporate this new information into their evaluations of the company, and begin to apply growth-company criteria in their evaluations. The composition of investors may well change as growth investors buy shares and investors who want a safer haven for their funds switch into other utility stocks. But there is little reason to believe that investors – particularly growth investors – would willfully ignore information that they have a strong interest to notice.

    SBC itself admits that it is capable of raising the capital needed for the national-local strategy as a stand-alone company.22 In addition, the behavior of SBC’s own stock price suggests that capital markets will take notice when a local exchange carrier transforms itself into a growth company. SBC is known as one of the more aggressive, growth-oriented local exchange carriers. As a result, its stock trades at a higher earnings multiple than BellSouth, Ameritech, Bell Atlantic, and US WEST, and the latter three companies offer higher dividend yields.23 Recent media coverage of the electric utility industry, which is not yet nearly as deregulated and competitive as the telecommunications industry, also suggests that investors do indeed change their evaluation criteria as a company’s strategies and opportunities change. A recent Wall Street Journal article urged investors to judge utilities by the same criteria used to evaluate other companies. A fund manager quoted in the article advised, "[t]ry to understand as well as we can which utilities excel in what businesses, and which managements are best able to judge the new environment."24

    Although the earnings dilution argument is implausible, some of the other dilution-oriented arguments put forth by the applicants make more sense. It should be intuitively obvious that the merged SBC-Ameritech can draw on a larger pool of experienced executives to staff the expansion. In addition, the merged firm will have established business relationships with a larger number of large, multi-location customers, which may make rapid national expansion more viable. For these and numerous other reasons presented in this Comment, we believe the Applicants have made a strong case for the merger even in the absence of the earnings dilution argument.

    Market dynamism mitigates market power.

    Market concentration provides an especially misleading picture of the state of competition in the presence of rapid change. If costs are falling or quality attributes are improving rapidly over time, even incumbent firms in highly concentrated industries face substantial competitive pressures. If they are to retain their dominant position, the incumbents must continually improve their price and/or quality of service.25

    In suggesting that market dynamism mitigates market power, we do not mean to argue that barriers to entry, in the form of sunk costs, are low or nonexistent. We are not attempting to invoke the theory of contestable markets.26 Our argument makes a different point: The more rapid the pace of change, the easier it is for entrants to leap over the barriers to entry thought to benefit the incumbents, even if entry involves substantial sunk costs. Faced with such competitive pressures, incumbents have stronger pressures to perform than the statistics on market concentration or a measurement of sunk costs would lead one to believe.

    To take the most direct example: All Bell companies are currently thought to benefit from the enormous sunk cost created by their network of copper wires. A number of technology forecasters, however, believe that the cost of these copper wires will soon become an unrecoverable albatross around the incumbent local exchange carriers’ necks, rather than a barrier to entry that protects profits. One suggests that the cost of wireless calls could fall to 5 cents per minute within five years, and local exchange carriers could lose up to 50 percent of their calling revenues within 10 years as a result of lower-cost competition from both the wireless and cable industries.27

    Evidence exists that even local telephone service, the most concentrated market at issue in this proceeding, is capable of delivering substantial improvements in price performance as a result of continuous improvement and technological change. Consider, for example, the changes in the monthly price of local service in the 10 years following the breakup of AT&T. Many observers feared that the breakup, combined with the Commission’s implementation of the Subscriber Line Charge to reduce the subsidy flowing from long-distance to local service, would result in significant price increases. The subscriber line charge did raise the price of basic local service by a few dollars per month in the mid-1980s. By 1994, however, the real price of basic local service was about where it was in 1984, the year of the AT&T breakup. By 1994, real average local rates, including the subscriber line charge, actually fell by 13 percent from their 1986 peak. (See the accompanying table.)

    Real Monthly Local Telephone
    Rates (In 1995 Dollars)

    1984 $19.58
    1985 $20.59
    1986 $22.43
    1987 $22.35
    1988 $21.35
    1989 $21.54
    1990 $20.74
    1991 $20.88
    1992 $20.31
    1993 $19.85
    1994 $19.54
    Source: Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice (Fairfax, Va.: Center for Market Processes, 1997).

    Productivity growth is the "magic" that made it possible for local exchange carriers to lower their own rates by a large enough amount to offset the subscriber line charge. A number of industry experts believe that local exchange carriers can achieve productivity increases of between 5 percent and 7 percent per year.28 This Commission has itself recognized the potential for ongoing improvement, through its choice of a 6.5 percent productivity offset for the price cap on local access charges.29

    If these kinds of productivity gains are indeed possible, they serve as a counterweight to market power, for two reasons. First, as the Commission has recognized, to the extent that rapid increases in productivity reduce marginal costs, even a firm with market power has an incentive to lower its prices and, or, improve the quality of service.30 Second, the existence of large productivity gains also allows us to infer something about the prospects for rapid change in the market. A market with rapid productivity increases surely qualifies as more dynamic than a market with slow productivity increases. The more dynamic the market, the more vulnerable incumbent firms are to potential competitors.

    For these reasons, the local exchange market may face more competitive pressure than concentration statistics or measures of sunk costs would imply.

    III. THE MERGER COULD DELIVER LARGE CONSUMER BENEFITS

    Principal benefits claimed by the companies.

    The Applicants project that their merger will produce a number of substantial benefits. Projected cost savings include $1.17 billion in expenses and $260 million in capital expenditures. They also project a revenue gain of $778 million, largely through the adoption across companies of best practices in marketing and sales.31

    The cost savings are not guaranteed, but they seem plausible given SBC’s previous experience with the Pacific Telesis merger. We also agree that the $778 million should count as a consumer benefit. Because the figure assumes no price increases, it simply represents the value consumers attach to services that they would not have bought if the merger had not led to the adoption of best marketing and sales practices. As a matter of economic theory, the $778 million figure is actually a lower-bound estimate of consumer value, because consumers must receive a bundle of services worth more than $778 million if they are to be motivated to make the exchange.32

    We do take issue with one of the alleged benefits of the merger. The Applicants briefly suggest that the merger can be expected to create jobs, based on the job growth experienced at Pacific Telesis following the SBC-Pacific Telesis merger.33 From an economic perspective, however, the creation of jobs is a cost – not a benefit.34

    The benefits of economic activity are the satisfaction of human desires by the goods and services produced; one of the associated costs is that people have to work to produce the goods and services. The most advantageous system of all would be one in which every member of society could obtain all of the valuable products and services he or she could use without working. There would be no jobs, but our standard of living would be quite high, since we would have plenty of goods and services, plus a lot of leisure time.

    Conversely, it is also possible to imagine a society with plenty of jobs but a low standard of living. A society in which everyone simply dug holes in the ground only to fill them back up again would have full employment, but would produce little of value to consumers, and the standard of living would be quite meager. If the Applicants really want to offer job creation as a benefit of the merger, they should propose to hire 10,000 people to dig holes and to fill them back up again!

    It would be much better if the Applicants could produce all of the savings and business expansion they project without hiring any more employees, for then the cost to consumers would be lower than would otherwise be the case. Of course, this is probably not possible, and we do not begrudge anyone an employment opportunity that produces something that consumers value. But we remain wary of claims that a merger that creates jobs is inherently good, along with the implications that a merger that creates more jobs is even better, and a merger that reduces jobs is bad.

    How much of these benefits will flow to consumers?

    The answer to this question depends on the particular type of market under consideration. The effects of the merger on consumers might be different in competitive and in regulated markets. In addition, the merger creates opportunities for interactions across different kinds of markets that could enhance competition.

    Competitive markets.

    It is well-recognized that competitive markets force firms to pass the benefits of improved efficiency through to consumers. However, a careful distinction must be made to understand how competition works in real markets as opposed to textbook theory.

    In the textbook model of competition, the presence of numerous identical firms, none of which possess a cost or quality advantage, assures that all efficiency gains accrue to consumers, and all firms earn only a "normal" rate of return equivalent to what investors’ capital would earn in its next best alternative use.35 In real markets, firms are differentiated, and individual firms often possess unique cost or quality advantages. Competition forces the most efficient firm to offer consumers a combination of price and quality at least as good as that offered by the next most efficient rival. The cost savings or other efficiency benefits created by the most efficient firm are thus never fully passed through to consumers; the firm earns superior profits that reflect its superior efficiency.36 A great deal of scholarly research suggests that such firm-specific effects contribute much more to corporate profitability than monopoly rents generated by market structure.37

    These profits, and the absence of a 100 percent pass-through, do not indicate monopolistic exploitation. They are simply a reward earned by superior firms that promotes continuous improvement. Over time, consumers reap larger benefits by allowing firms to keep this reward than by expropriating it. For this reason, we caution the Commission to avoid inferring that markets are not competitive in the absence of a 100 percent pass-through of efficiencies to consumers.

    Regulated markets.

    In most regulated markets, such as local exchange and exchange access service, SBC and Ameritech are subject to some form of price cap regulation. (See accompanying table.) Under price cap regulation, there is no guarantee that all of the efficiencies created by this merger will immediately be passed through to consumers.

    States With Price Cap Regulation of Ameritech and SBC

    State Inflation Index Productivity Offset Year Effective Other
    Arkansas 75% of GDP-PI None 1997
    California GDP-PI 5% 1994 Rate freeze thru 1998
    Illinois GDP-PI 4.3% 1994 Up to 2% penalty for poor service
    Indiana None None 1994 Rates capped
    Kansas None None 1990 Rates frozen
    Michigan Detroit-area CPI 1% 1995
    Missouri None None 1994 Rates frozen thru 1998
    Nevada None None 1995 Prices frozen at rates est. in rate case
    Ohio GDP-PI 3% 1995 Penalties for poor service
    Texas CPI Set by Commission 1995 4-year rate freeze
    Wisconsin GDP-PI 3% 1994 Reward/penalty for service
    Source: National Regulatory Research Institute.

    This does not, however, mean that consumers do not benefit. The purpose of price cap regulation is to give regulated firms superior incentives to reduce costs. It is an attempt to mimic the competitive process in real markets, where the most efficient firms earn a premium over the normal rate of return as a reward for their efficiency.

    When price cap regulation is instituted, the regulated firm agrees to a rate freeze or a formula for rate reductions in exchange for the opportunity to earn higher rates of return if it can improve the efficiency of its operations. One possible way of improving efficiency is to engage in cost-reducing mergers, and the Applicants have documented more than $1.25 billion worth of cost savings they expect to realize. It is positively perverse to tell firms that they cannot merge because price cap regulation does not force them to pass the benefits through to consumers. Consumers already received a guaranteed benefit, in the form of the price cap, and the firm agreed to the cap so that it could profit if it found opportunities to improve efficiency. We can think of no more effective way to undermine the efficiency incentives created by price cap regulation than to prohibit firms from acting on, and profiting from, cost-reducing opportunities they identify after the price cap is in place.38

    Even in the worst case scenario – a price cap too high to constrain a monopolist from exercising market power – the merged firms have incentives to pass the benefits of increased efficiency through to consumers if the efficiencies reduce marginal costs. The Commission itself recognized this principle in its discussion of the NYNEX-Bell Atlantic merger.39

    How much of the prospective savings represent a reduction in marginal costs? The answer depends on one’s time frame; some costs may be fixed in the short run but marginal over a longer time period. Based on the information the Applicants provided, we have attempted to identify some categories of cost savings that likely affect short-run marginal costs, some that do not affect short-run marginal costs, and others that may contain a mixture (or are impossible to classify based on the information provided). As the accompanying table shows, approximately $283 million can probably be classified as a reduction in short-run marginal costs, and another $776 million may contain some short-run marginal cost elements.

    It is also worth noting that the fact that some items do not affect short-run marginal cost does not mean that these cost reductions produce no benefits for consumers. "Costs that are fixed in the short run become variable in the long run, and thus reductions in fixed costs can result in lower prices or improved entry opportunities over the longer term."40

    Short-run marginal cost (Total: $283 million)

    $121 million reduction in procurement expenses
    $115 million provision and maintenance
    $10 million collections
    $22 million operator services
    $15 million outside sales
    Not short-run marginal cost (Total: $672 million)

    $260 million reduction in procurement (capital expenditures)
    $85 million marketing, product development, advertising
    $54 million real estate
    $45 million switching/network engineering
    $17 million network administration
    $10 million telemarketing
    $201 million administration
    Mixture or not enough information to classify (Total: $776 million)

    $227 million information technology
    $24 million motor vehicle expenses
    $35 million demand sales
    $13 million pay phone
    $31 million industry markets
    $146 million other businesses
    $300 million long distance
    In addition to these cost savings, one must determine whether the $778 million in new sales would count as a benefit passed through to consumers if price caps are insufficient to constrain market power. Analysis of these new sales under the standard textbook monopoly framework is problematic, because the textbook model assumes that all firms have already adopted best practices, and all customers have perfect information about the price and performance characteristics of all service options. In this framework, the only way a firm could increase sales would be through lower prices. The SBC executive who constructed this estimate, however, appears to have assumed that prices would remain unchanged.41 How could the merged firm increase sales without lowering prices?

    The answer to this question lies in the realization that, contrary to the assumption of the textbook model, not all firms in real markets are employing best practices all the time. Instead, best practices take time to diffuse across an industry. Mergers can hasten this diffusion, as best practices can be transferred within an organization at a lower communication cost and without the fear that strategically important knowledge will be misused by outsiders.42

    Martin Kaplan’s affidavit describes the gain in sales largely as a result of the spread of best practices in marketing and sales.43 In economic terms, these practices can best be understood as a way of increasing demand (shifting the demand curve to the right) by making more customers aware of services that they would like to buy if they knew about them. There is no reason that a firm with market power – or even a monopolist – would not find this diffusion of best practices and resulting expansion of sales in its best interest. Therefore, the entire $778 million should be counted as a benefit that will accrue to consumers even if the merged firm possesses substantial market power.

    In short, even in the worst case, the merged firms have incentives to flow a substantial portion of the benefits through to consumers.

    The proposal to offer out-of-region residential service is credible.

    The Applicants claim that their business plan would put them in competition for residential as well as business customers in 30 large markets outside their own territory. If this competition actually occurs, it could confer substantial benefits on residential customers.

    As a rule, CSE Foundation is skeptical of this type of claim, largely because of the history of telecommunications regulation. For much of this century, regulation has sought to keep local residential rates below actual cost by charging businesses artificially high prices.44 Such policies encourage the average consumer to think he is a beneficiary of regulation, because the lower residential rates are highly visible, but the higher costs of telephone service for businesses are hidden in the prices the customer pays for all other goods and services.45 In our view, this is nothing but a shell game that actually makes consumers, on the whole, worse off by reducing the productive capacity of the American economy.46 Nevertheless, since this is how the game is played, it would not surprise us at all if SBC and Ameritech propose to offer local residential service simply as a regulatory quid pro quo to get approval of the merger and an opportunity to win (or retain) more business from their large corporate customers. If residential service turns out to be unprofitable, we would not expect a significant effort to be sustained over time.

    In this case, though, the Applicants’ proposal to offer residential service in the new markets they enter is credible because it reflects fundamental economic realities. Once their switches and fiber network are in place in the new cities, they have a natural incentive to hook up residential subscribers in order to maximize throughput. In addition, unlike some of the competitive local exchange carriers, SBC and Ameritech already have substantial experience marketing and providing service to residential subscribers.

    In addition, the distinction between residential and business markets is itself blurring because of the growth in telecommuting. When telecommunications provide the crucial link to let people use their homes extensively for business, the regulatory distinction between "business" and "residential" customers makes less sense. Telecommuting is a significant and growing phenomenon,47 especially for the types of large companies that SBC and Ameritech propose to follow out of their home regions:

    The most recent survey by FIND/SVP shows that approximately 11 million Americans telecommuted in 1997, up from 8.5 million in 1995 and 9.7 million in 1996. Telecommuting has grown at an average annual rate of 15 percent over the past two years.48
    In a May 1997 survey, Watson Wyatt Worldwide found that 51 percent of America’s largest employers offer telecommuting.49
    Approximately 30 million Americans do some part of their work at home; this figure includes telecommuters, people who bring work home in the evening, and home-based businesses.50
    Jack Nilles, the former professor and consultant who invented the term "telecommuting," projects that 24.7 million employees – 18 percent of the workforce – will telecommute by the year 2000, and 30 million will do so by the year 2005. Nilles has a strong record; actual survey results have tracked his forecasts for a number of years.51
    Telecommuting is an especially important phenomenon, because a phone company serving a business with telecommuters already has access to a pool of employees who are natural candidates to subscribe to its residential service. Both the corporate client and its employees have a strong interest in ensuring that telecommunications services in the home provide seamless connections to the business location. A phone company serving both locations is in a strong position to guarantee seamless connectivity. In addition, due to the pre-existing relationship with the employer, marketing costs for this group of residential customers will likely be lower. The phone company can thus leverage52 its business relationship with the company into an opportunity to serve employees.

    The merger creates incentives for voluntary unbundling by SBC and Ameritech.

    Even after passage of the 1996 Telecommunications Act, the issue of unbundling elements of local telephone service has remained contentious. Long-distance and competitive local exchange carriers sometimes claim that the local phone companies are dragging their feet on unbundling. Local phone companies claim that they are complying with the Act as rapidly as possible, and they claim that long-distance companies have refrained from entering the local service market in order to prevent local companies from receiving permission to enter the long-distance market.

    The SBC-Ameritech merger and accompanying business strategy give SBC and Ameritech superior incentives to unbundle as rapidly as possible. The principal reason is that success of the national-local strategy depends critically on their ability to obtain unbundled local service from carriers outside of their current service territories. "SBC and Ameritech themselves plan to rely heavily on unbundled elements in implementing the National-Local Strategy."53 It is true that the merged companies plan to place their own switches and fiber optic cable in the 30 largest markets outside their territories. However, in order to reach residential customers in those cities, they will still need to access the incumbent local carrier’s lines. SBC and Ameritech will likely be frustrated in this goal if they themselves engage in behavior that frustrates other carriers who want access to unbundled elements of their facilities in their own service territories.

    The two companies plan capital expenditures of more than $2 billion and operating expenses of $23.5 billion over 10 years to enter other local markets.54 These expenditures will lose most of their value if the national-local strategy fails. In essence, SBC and Ameritech are pledging billions of dollars as a hostage that they would lose if they engaged in foot-dragging on unbundling that would cause the national-local strategy to fail.

    The merger creates a "maverick firm" in regard to unbundling.

    The Commission has previously noted that a merger can create consumer benefits "by enhancing the incentive of a maverick firm to lower price or by creating a new maverick firm."55 The proposed merger, in combination with the proposed expansion into new territories, creates a new maverick firm that has incentives different from those of a typical local exchange carrier.

    If all incumbent local exchange carriers largely confine their operations to their own regions and to lines of business that do not require purchase of unbundled network elements from other local exchange carriers, then all might have an incentive to resist unbundling in order to preserve barriers to entry. In contrast, the firm formed by the SBC-Ameritech merger will have significant operations in 30 markets outside its local service territory. The success of those operations depends critically on effective unbundling by the local exchange carriers in those markets. The national-local strategy thus gives the merged firm an interest in other firms’ unbundling efforts similar to that of the interexchange carriers and competitive local carriers. In the battle over unbundling, the interexchange and competitive local carriers would acquire an ally with considerable knowledge of local exchange operations. The appearance of this ally can only hasten the process of unbundling in markets outside of the current SBC-Ameritech service territory.

    Even if the consumer benefits are unsure, the merger should be allowed to proceed.

    The Commission’s decision on this merger need not hinge on the size and likelihood of the consumer benefits. As the Commission noted in its decision on the SBC-Pacific Telesis merger, "A demonstration that benefits will arise from the merger is not, however, a prerequisite to our approval, provided that no foreseeable adverse consequences will result from the transfer."56 We believe that this merger poses no more of a threat to competition than the SBC-Pacific Telesis merger. Therefore, even if some of the prospective consumer benefits are speculative and uncertain, the merger should be allowed to proceed.

    IV. CONCLUSION

    All mergers are by nature speculative. Some succeed, and others eventually turn out to have been based on mistaken judgment or perceptions. Nevertheless, the proposed merger of SBC and Ameritech appears to be based on a plausible understanding of the way telecommunications markets are changing.

    Regardless of whether the merger ultimately succeeds or fails as a business proposition, the Commission should approve it. There is no risk that the merger will harm consumers through monopolistic exploitation, and there is credible evidence that it will produce benefits for consumers.

    Respectfully submitted,

    Matt Kibbe
    Executive Vice President
    Citizens for a Sound Economy Foundation
    1250 H Street, N.W., Suite 700
    Washington, D.C. 20005

    October 14, 1998

    Footnotes

    1See Peter F. Drucker, "Management’s New Paradigms," (Forbes, Oct. 5, 1998) pages 152-177. What Drucker asserts as a general rule for the management of knowledge workers may be applied to telecommunications regulation as well: "[E]very seasoned executive has learned, few policies remain valid for as long as 20 to 30 years. Nor do most assumptions about the economy, about business, about technology remain valid longer than that."

    2See Alvin Toffler, The Third Wave (New York: Bantam, 1989); Alvin and Heidi Toffler, Creating a New Civilization (Atlanta: Turner Publishing, 1995).

    3To appreciate the futility of this distinction, note that a busy executive who phones her doctor from the office is considered a "business" customer, but she is considered a "residential" customer when she performs a Web search from home to get data for a business report.

    4We do not mean to imply that the SBC-Ameritech strategy is the only possible successful strategy in the new telecommunications market. There will likely also be a continued need for niche players who earn business from particular groups of consumers due to their superior knowledge of those consumers’ needs. But it seems clear that there will always be room in the market for a number of companies offering a wide scope of services combined with an international reach.

    5SBC-Ameritech Application at 58.

    6In Re Pacific Telesis and SBC Communications (Jan. 31, 1997), para. 18; In the Applications of NYNEX and Bell Atlantic (Aug. 14, 1997), para. 138.

    7One of the most recent and exhaustive analyses of competition in the long-distance market concluded that there is substantial competition in both the interstate inter-LATA and intrastate inter-LATA markets, although not perfect competition. The authors cite rate regulation as the main reason this market has not been more competitive. See Robert Crandall and Leonard Waverman, Talk is Cheap (Washington, D.C.: The Brookings Institution, 1995) at 158-65.

    8Ibid., para. 24.

    9Sigman Affidavit.

    10Osland Affidavit; Weller Affidavit, paras. 31-33.

    11See William Halal, Ali Geranmayeh, and John Pourdehnad, Internal Markets (Wiley, 1993); Russell Ackoff, The Democratic Corporation (Oxford, 1994); Jerry Ellig, "Internal Markets for Corporate Services," Center for Market Processes Working Paper (1992).

    12Oliver Williamson, The Economic Institutions of Capitalism (Free Press, 1985).

    13Colin Camerer and Ari Vepsalainen, "The Economic Efficiency of Corporate Culture," Strategic Management Journal 9 (1988), pp. 115-26; Jerry Ellig, "Internal Markets and the Theory of the Firm," Managerial and Decision Economics, forthcoming.

    14David J. Teece, "Economies of Scope and the Scope of the Enterprise," Journal of Economic Behavior and Organization 1 (1980), pp. 223-47.

    15Peter Senge, The Fifth Discipline (New York: Doubleday, 1991).

    16Richard N. Langlois and Nicolai J. Foss, "Capabilities and Governance: the Rebirth of Production in the Theory of Economic Organization," Manuscript (Nov. 5, 1996).

    17SBC-Ameritech Application at 49l.

    18Kahan Affidavit, paras. 48-54.

    19Kahan Affidavit, para. 22.

    20Carlton Affidavit, Table 2.

    21SBC-Ameritech Application at 51; Weller Affidavit, para. 34; Kahan Affidavit, paras. 79-80.

    22Kahan Affidavit, para. 75.

    23Based on price to earnings and yield data reported in The Wall Street Journal (Oct. 1, 1998).

    24Linda Sandler, "Beyond Dividends," The Wall Street Journal (Sept. 14, 1998) at R15.

    25David J. Teece and Mary Coleman, "The Meaning of Monopoly: Antitrust Analysis in High Technology Industries," Antitrust Bulletin, forthcoming.

    26The theory of contestable markets, which rigorously examines the role of sunk costs in deterring entry, asumes a world of perfect information and no innovation. It simply does not deal with a world in which entrants or incumbents might have access to superior technology or other superior resources. The principal developer of the theory notes:

    [P]erfect contestability, again like perfect competition, threatens to rule out entirely the reward mechanism that elicits the Schumpeterian innovative process. This mechanism … rests on the innovator’s supernormal profits, which are permitted by the temporary possession of monopoly power flowing from priority in innovation. Since perfect contestability rules out all market power, that is, since it permits immediate entry of imitators of any innovation, the market mechanism’s main reward for innovation is destroyed by that market form. In short, it is clearly no panacea that can bring dynamic and static efficiency at the same time.

    27See William J. Baumol and Janusz A. Ordover, "Antitrust: Source of Dynamic and Static Inefficiencies?" in Thomas M. Jorde and David J. Teece, Antitrust, Innovation, and Competitiveness (N.Y.: Oxford, 1992); William Baumol, John Panzar, and Robert Willig, Contestable Markets and the Theory of Industry Structure (New York: Harcourt Brace Jovanovich, 1982).

    28G. Christian Hill, "Consultant’s Call," The Wall Street Journal (Sept. 21, 1998) at R27.

    29Peter K. Pitsch, The Innovation Age (Hudson Institute and Progress & Freedom Foundation, 1996), p. 99. For further study of telecommunications mergers in the Innovation Age, see also, Peter K. Pitsch, "An Innovation Age Perspective on Telecommunications Mergers," Citizens for a Sound Economy Foundation, Issue and Answers (Nov. 13, 1996) No. 43.

    30In May 1997, the Commission set a productivity factor, or "X-Factor," for access charges at 6.5 percent less the amount of inflation. See Report No. CC 97-22.

    31In the Applications of NYNEX and Bell Atlantic (Aug. 14, 1997), para. 169.

    32Kaplan Affidavit.

    33In economic jargon, the company must leave consumers with at least a little bit of "consumer surplus" in order to motivate the purchases.

    34SBC-Ameritech Application at 42; Kahan Affidavit, para. 94.

    35See, for example, Richard McKenzie, The Great American Job Machine (New York: Universe, 1988).

    35See, e.g., Hal Varian, Microeconomic Analysis, 2nd ed. (New York: W.W. Norton, 1984) at 82-85.

    36Shelby D. Hunt, "The Resource-Advantage Theory of Competition," Journal of Management Inquiry 4:4 (December 1995), 317-32; Shelby D. Hunt and Robert M. Morgan, "The Comparative Advantage Theory of Competition," Journal of Marketing 59 (April 1995), 1-15; Robert Jacobson, "The ‘Austrian’ School of Strategy," Academy of Management Review 17:4 (1992) , 782-807; Harold Demsetz, "Industry Structure, Market Rivalry, and Public Policy," Journal of Law and Economics 16 (1973), 1-10. Note that the superior firm may have some measure of market power; it could charge a price that allows it to earn only a normal rate of return, but instead it chooses to charge a price just sufficiently low to garner business at the expense of the next most efficient competitor.

    37See Richard P. Rumelt, "How Much Does Industry Matter?" Strategic Management Journal 12 (1991), pp. 167-185. Rumelt estimated that industry and firm effects accounted for 8 percent and 46 percent, respectively, of a firm’s profit variability. Also see Jaime A. Roquebert, Robert L. Phillips, and Peter A. Westfall, "Market Versus Management: What ‘Drives’ Profitability," Working Paper, Texas Tech University. Roquebert, et. al. used a much larger data set, sampling from more industries and firm sizes, and found industry and firm effects to be 10 percent and 57 percent, respectively.

    38"[M]andating pass-through of all claimed efficiencies would undermine the incentives our price cap rules create for carriers to become more efficient." In the Applications of NYNEX and Bell Atlantic (Aug. 14, 1997), para. 207.

    39In the Applications of NYNEX and Bell Atlantic (Aug. 14, 1997), para. 169.

    40Gilbert and Harris Affidavit, para. 55.

    41Kaplan Affidavit, para. 7.

    42For a fuller explanation, see above, pp. 8-10.

    43Id.

    44See Wayne Leighton, "Telecommunications Subsidies: Reach Out and Fund Someone – Whether You Want to or Not," CSE Foundation Issues and Answers (Jan. 5, 1995). See also Crandall and Waverman, Talk is Cheap, at 76-95.

    45Economic scholarship demonstrates that policymakers and regulators have an incentive to adopt policies and regulation that combine visible benefits with hidden costs. See Richard Posner, "Taxation by Regulation," Bell Journal of Economics and Management Science 2:1 (Spring 1971), pp. 22-50; Michael Crew and Charles Rowley, "Toward a Public Choice Theory of Monopoly Regulation," Public Choice 57 (1988), pp. 49-67.

    46If public policy inflates the prices charged to highly price-sensitive customers, such as businesses, they will cut back their use of telecommunications a great deal. Lower local rates for customers who are not very price-sensitive, such as residential users, will transfer wealth to them but will not induce them to use much more telecommunications services. Therefore, the output of the telecommunications industry is inefficiently low. See Robert Crandall, After the Breakup, at 135-45; Wayne Leighton, Telecommunications Subsidies: Reach Out and Fund Someone.

    47The Center for the New West provided an early study of where knowledge workers make there homes in a 1991 study, "The Great Plains in Transition: Overview of Change in America’s New Economy." Center president Philip M. Burgess has named these workers Lone Eagles. In a Rocky Mountain News column (May 23, 1994) he wrote, "Lone Eagles are the first wave of those who are changing the way we live, work, play, learn and move around because of the telecommunications revolution. [They] may represent America’s most important lifestyle change since the rise of the two-wage-earner family of the 1970s."

    48"US Telecommuting Trend Surpasses 11 Million," at http://etrg.findsvp.com/prls/pr97/telecomm.html.

    49See http://www.langhoff.com/advice.html#stats.

    50Toffler and Toffler, Creating a New Civilization, at 87.

    51See http://www.jala.com.

    52We mean "leverage" here in the business strategist’s sense, not in the monopolistic sense.

    53SBC-Ameritech Application, at 79.

    54Kahan Affidavit, paras. 57-58.

    55In the Applications of NYNEX and Bell Atlantic, para. 169.

    56In Re Pacific Telesis and SBC Communications (Jan. 31, 1997), para. 2.