Regulation, Competition, and Universal Service in the IP Era

Published September 24, 2004

An August 25 article in the Wall Street Journal, “Phone Industry Faces Upheaval As Ways of Calling Change Fast,” analyzed the effect new technologies are having on the way telecommunications services are delivered, priced, and regulated.

Among other topics, the article discussed the pressure unregulated services–such as wireless and voice over Internet Protocol (VoIP)–are bringing to bear on traditional regulation, especially rate-setting mechanisms and cross-subsidy schemes. In particular, the article raised questions about the future funding of universal service, particularly in areas where, to date, telecom competition has not arrived.

There are pedantic and practical answers to the issue of universal service and intermodal competition in the era of IP. Neither is likely to make regulators happy. But there’s little choice but to confront reality considering the speed and inevitability of widescale adoption of IP and wireless services.

Pedantic Response to Universal Service

The pedantic answer is borrowed from Richard Posner’s classic essay, “Taxation by Regulation.” There, Posner, the former chief judge for the U.S. Court of Appeals for the Seventh Circuit, asserts that the purpose of regulation is not constraint of monopoly prices–it manifestly fails at that–but redistribution of benefits among different favored classes. In telecom, this explains universal service in all its implicit and explicit forms. The regulatory system redistributes “rents” from urban to rural and from business to residential and from long-distance service users to non-long-distance users.

Posner explains that the logic of this system presupposes it is a closed system. No one can be permitted to escape the regulated universe, because then the ability to effect the redistribution falls apart. Likewise, no one can be permitted to arbitrage the system too much or it again falls apart. Thus, regulation must keep all substitutable services within its domain or it cannot accomplish its aims, in this case universal service.

Yet the market is no longer closed. IP and wireless technologies today permit regulatory escape. Law, meanwhile, remains static, with categories that were invented for earlier iterations of the technology. As a result, states have jurisdiction (depending on the state statute) over wireline voice, but usually not wireless voice. Federal jurisdiction cleaves into two worlds, the relatively unregulated information services and the regulated telecommunications services. VoIP stresses these classifications to the breaking point. Thus, both law and our expectations of what regulation can accomplish must change.

It will no longer be possible to use the incumbents as a piggy bank to transfer costs or benefits. The open secret about markets is that they distribute goods and services efficiently, but not equally when unequal costs are involved. Consequently, higher-cost regions will have to pay those costs because they will no longer be blended into average cost rates.

Practical Answer to Universal Service

The practical answer to the universal service issue is much less encouraging, absent significant legal overhaul. In rural, non-competitive areas, the ability of a regulator to force cross-subsidy through implicit universal service mechanisms is dwindling, perhaps rapidly. Explicit mechanisms–state universal service funds (USFs), geographically averaged retail rates, and provider-of-last-resort requirements–are probably not much farther behind.

However, the very reasons those regions are less competitive is likely because of these explicit and implicit USF mechanisms in the first place. No one will enter a market where the retail prices are below cost or where service territory entry requirements force the obligation to serve high-cost customers.

Thus, universal service will have to be accomplished through a broadened contribution base (not that I necessarily endorse this) and a distribution method that decides first what is to be supported, a single voice line or a broadband connection, and second, how that support is apportioned. On the second question, I am partial to auctions if you can get two bidders.

In the end, I think the solution is to deregulate retail, let the rates trend toward cost, and then see where and whom you need to subsidize. In the interim, with the technological tumult and legal and regulatory institutions unable to catch up, there will be inevitable dislocation.

In the short run, I agree with the Journal‘s assessment that the incumbent Bell companies face huge challenges. Their advantages–an installed base of customers, an installed network base, and a competent labor force–have a downside: Customers will migrate to cheaper or more convenient platforms in an instant; the installed network base in a declining cost industry is a liability, not an asset; that competent labor force is high-wage union labor.

The incumbents are disadvantaged compared to wireless and cable, particularly when cable bundles VoIP, because these other platforms don’t have the regulatory burdens or universal service obligations of the incumbents. Fiber in some flavor–to the premises or to the node–is the incumbents’ multi-billion-dollar bet to stay alive.

Finally, I do think VoIP means the end of state regulation in large measure. The closed cross-subsidy world in which the states operated is slipping away onto multiple platforms, some of which are impossible to regulate. There may be some federal grant back to the states of certain powers, but the traditional roles of rate-setting, tariffing, and service area definition are over.

Ray Gifford ([email protected]) is president of the Progress and Freedom Foundation. This essay is adapted from an essay originally posted on the PFF blog September 2, 2004.