Contents:
Comments of the
Communications Workers of America
Introduction
The Federal Communications Commission's decision to require that LEC price caps for access charges fall at the rate of 6.5 percent annually will cause serious damage to the local phone industry. The evidence clearly shows that productivity growth in this sector has not been fast enough to support this rate of price decline. This rate of price decline will not allow the industry to earn a rate of return that is remotely comparable to that available in other sectors of the economy. Unless the industry can force large reductions in wages and benefits on its workers, the inevitable consequence will be disinvestment in the telephone industry. A sustained period of disinvestment will diminish the quality of telephone service and may even affect access in some cases. Neither the squeezing of workers in the industry, nor large scale disinvestment from the industry, can be viewed as desirable consequences of FCC regulation.
The basis for the FCC decision was its assessment of recent productivity growth in the industry and trends in input prices. It concluded that these trends warranted 6.0 percent annual reductions in LEC access charges measured against the rate of inflation. Furthermore, it ruled that access charges should fall an additional 0.5 percentage points as a result of further deregulation of the industry. The FCC based this increment on the assumption that increased competition will raise the rate of productivity growth by approximately 0.5 percentage points annually and that this benefit should be passed on to consumers.
The FCC mandated price reduction is excessive for three reasons:
- Annual productivity growth in the industry has been close to 3 percent, not 6 percent;
- Increased competition is likely to lower the rate of productivity growth for incumbent LECs, not raise it; and
- There have been recent changes to the GDPPI, which lower it relative to the true rate of inflation by approximately 0.2 percentage points annually. This means that the FCC ruling requiring a 6.5 percent annual decline in access prices measured against the GDPPI going into the future implies an annual rate of decline of approximately 6.7 percent relative to the GDPPI measure that was in place over the period where the FCC measured productivity in the industry.
These reasons will be examined in turn.
The Record on Productivity Growth
The FCC received a series of studies of total factor productivity growth among LEC carriers from the affected parties and then produced its own study based on this input. To construct its methodology, the FCC relied primarily on a study done by John Norsworthy for AT&T and Christensen Associates for the United States Telephone Association (USTA). The Christensen Associates study estimated that annual total factor productivity growth among LEC carriers was on average 3.0 percentage points higher than in the business sector as a whole for the years 1988-95. The Norsworthy study estimated that productivity growth averaged 7.2 percentage points higher than in the business sector as a whole over the same period. Careful analysis shows that Christensen Associates closely followed the standard economic methodology in carrying through their analysis whereas the Norsworthy study made several important errors (see appendix). As a result, the estimates of productivity growth produced by this study have to be given far more credibility than the estimates from the Norsworthy study. This is a conclusion largely shared by the FCC. It is worth noting in this regard, that the FCC's own estimate of average productivity growth differential for this period, 3.2 percentage points, does not differ significantly from the estimate produced by the Christensen Associates study.
Nonetheless, the FCC ruled that recent trends justified a 6.0 percent annual reduction in access charges, in spite of concluding that the productivity differential was little more than half this much, because it also claimed that input prices for LEC carriers had fallen at the rate of 2.8 percent annually relative to prices in the economy as a whole. The FCC projected that this rate of decline in input prices can be expected to continue for the foreseeable future, and therefore incorporated this decline into its ceiling on access charges.
According to the FCC's own analysis, the recorded decline in input prices is entirely attributable to a decline in the cost of capital. The analysis shows that the price of material inputs for the LECs has risen at the rate of 2.5 percent annually over the period 1988-95, while the price of labor inputs has risen at the rate of 4.2 percent. Neither of these rates of inflation differ significantly from the 3.2 percent rate of inflation in input prices for the non-farm business sector as a whole. (The somewhat more rapid rate of growth of labor input prices than material input prices is typical for the economy as a whole.)
The FCC's conclusion that there has been a 2.8 percent annual decline in the relative price of inputs for LECs rests entirely on a 2.6 percent annual absolute decline in the price of capital inputs. This decline in input prices has already created a situation where the return on capital investment is substantially lower for LECs than for other industries. The data used in the FCC analysis indicates that the before tax rate of return for the LECs has fallen from 10.7 percent in 1988 to 7.9 percent in 1995. The before tax rate of return in the corporate sector as a whole in this period rose from 7.3 percent in 1988 to 10.8 percent in 1995. (It rose further to 11.4 percent in 1996.)
The projection of a continuing decline in the future will imply that the return will fall further relative to the economy-wide average. If this trend continues to the year 2000, the rate of return for the LECs will be just 5.1 percent. If such a decline actually occurs, it will inevitably lead to disinvestment in the industry, since firms will not be willing to invest at a sub-market rate of return. The fact that these sub-market rates of return are being projected for a period when the industry is being opened to competition should increase the likelihood of disinvestment, since the newly competitive environment will be adding a very substantial degree of risk to new investments in the industry.
In short, the trend of declining input prices in the FCC's analysis cannot be projected into the future. The implication of projecting this trend into the future is that the rate of return for LECs will be substantially less the return in other sectors of the economy. Firms cannot be expected to undertake new investment in an industry that offers returns that are substantially less than those available elsewhere. The FCC clearly erred when it incorporated this trend into its price cap ruling.
The Impact of Competition
As noted earlier, the FCC added 0.5 percentage points to the annual reduction in access charges because of a presumed productivity premium associated with further deregulation of the industry. While deregulation may offer some opportunities for increasing productivity, these should be more than offset by other factors that will lower productivity. There are four reasons why competition should lead to lower productivity growth for the incumbent LECs. First, the sectors in which they lose market share are likely to be the sectors with the highest profit margins. Second, as a result of losing market share, incumbent LECs will see slower demand growth, which will limit the gains from the economies of scale that exist in the industry. Third, the FCC ruling requires the incumbent LECs to ensure compatibility with new entrants. Fourth, competition itself adds substantial sales and marketing costs.
The FCC ruling does not dispute the validity of either of the first two points. It explicitly acknowledges both that the loss of high margin categories of output will lower measured total factor productivity and that slower output growth due to competition will lead to a loss of scale economies. However, in both cases, the FCC ruling explicitly states it is declining to take into account the negative impact these two factors have on total factor productivity growth in setting its price ceilings. The analysis produced by Christensen Associates for the USTA indicated that the reduction in total factor productivity growth associated with the loss of high margin sectors would be approximately 0.4 percent annually. They also noted the standard estimates of the size of the scale economies in the industry as being between 0.3-0.5 percent. This means that a reduction in output of 1.0 percent would led to a fall in total factor productivity growth of between 0.3-0.5 percent. Both of these are sizable effects which the FCC has explicitly chosen to ignore in setting its rate ceilings.
The costs associated with maintaining compatibility between the systems established by the incumbent LECs and the systems that will be developed by competitors, such as intraLATA toll dialing parity, number portability, and an electronic system for wholesale ordering, provisioning and billing, are also not factored into the calculations of the FCC. These costs can be substantial, although it is difficult to quantify them with much precision. In addition, introducing competition will require incumbent LECs to engage in marketing and sales efforts that are unnecessary in the current regulatory environment. Again, these costs are difficult to quantify in advance of deregulation, although the expenditures made by the long distance carriers for these activities indicates that the expenses are likely to be substantial. (The discounts given as incentives are not properly counted as costs since these are savings for consumers, but sales personnel and advertising expenditures that are unnecessary in the current regulatory environment do have to be seen as necessary costs in a competitive environment.)
To sum up, the FCC ruling has assumed that the switch to a competitive environment will lead to further gains in productivity, and therefore added 0.5 percentage points annually to the size of mandated price reductions. Although there are some reasons for believing that deregulation will have positive effects on productivity growth, these should be more than offset by the negative impact that competition will have on the productivity growth on incumbent LECs. In some cases, such as the loss of high margin sectors and reduced scale economies, this negative impact can be reasonably well quantified. In other cases, the cost of maintaining compatibility and carrying through sales efforts, the costs are less easily quantified at present, but may nonetheless be substantial. In any case, there is good reason to believe that opening the industry to competition will lead to lower total factor productivity growth in the future than was achieved in the past. Therefore the FCC has erred by increasing the size of the mandated price reductions as a result of deregulation.
Inconsistent Price Indices
There have been changes made to the gross domestic product price index over this period which have lowered it relative to the true inflation rate. Specifically, there have been changes in the treatment of medical care prices in the years 1994-5 that would have the effect of lowering the measured rate of inflation in these areas by approximately 3.0 percent annually. Since these areas comprise roughly 8.0 percent of the GDPPI, these changes should have the effect of lowering the measured rate of inflation by approximately 0.2 percentage points compared with the measure that was in place for the period from 1988-95. This period was the basis for the comparison between total factor productivity growth in the non-farm business sector and the LECs. Had the current methodology been used during the 1988-95 period, it would have raised the measured rate of total factor productivity growth in the non-farm business sector by approximately 0.2 percentage points, thereby reducing the difference in growth between the industry and the broader non-farm business sector by 0.2 percentage points.
This means, that if the FCC concluded that the evidence warranted a reduction in annual access charges by 6.5 percent annually compared to the GDPPI that had been in place through most of the period from 1988-95, an annual reduction of 6.3 percent would be warranted when measured against the GDPPI that is currently in place.
Conclusion
The FCC requirement that LECs lower price ceilings on access charges by 6.0 percent annually is not supported by recent trends in productivity growth. Actual productivity growth in the industry has only been about 3.1 percent in recent years. Furthermore, the introduction of competition to the industry is likely to lower productivity growth for incumbent LECs below its recent trend. In addition, the fact that the price index against which rate reductions are to be measured has been changed to record a lower measured rate of inflation relative to the actual rate means that the required rate reductions are even larger than the FCC intended.
Requiring rate reductions that are substantially greater than is warranted by productivity growth in the industry can have two effects. These rate reductions will lead to a further reduction in the rate of return in the industry, which is already below the average in the corporate sector. The middle and long-term implications of sustaining rates of return that are below market levels will be disinvestment in the industry. Alternatively, it can lead the LECs to try to extract extraordinary concessions from their employees so that they can maintain reasonable rates of return.
A policy that forces substantial wage and benefit cuts on workers in the communications industry or that leads to disinvestment in such a crucial sector of the economy cannot be desirable. It is important that the FCC's ruling be reconsidered and replaced with one that is better supported by the evidence on sustainable rates of productivity growth.
