One-on-one tariffs block competition

Aug. 1, 2000

A vestige of the pre-Telecom Act era, one-on-one tariffs allow incumbents to retain major customers and wall them off from competitors who starve for large subscribers. Meanwhile, regulators do nothing.

By Stephen N. Brown

Sign up the most profitable customers first, then work your way down the profit ladder. This is the strategy of competitive local-exchange carriers (CLECs) trying to enter the incumbents' markets. The strategy is rational, given what Peter Huber wrote in the Wall Street Journal Sept. 7, 1993: "In telecommunications, most customers don't matter. The customers who matter are the 10% who in fact generate 90% of telephone revenues." Revenue distribution in 2000 may not be as skewed as it was in 1993, but skewed it is, because incumbents and CLECs battle for major customers. The competitors are losing-they have a minuscule count among such customers.

For example, the Utah Public Service Commission's most recent bi-annual report stated, "The market is still controlled by a single firm [US West]. Competitors serve fewer than 1.7% of all lines....[C]ompetitors serve about 5% of the business lines in [the incumbent's] service area." The Utah commission cited several reasons for "slower than expected movement to competition," which included "the interests of incumbents to protect current and future market share" and the "strategy of competitors to serve only the high-volume, low-cost customers."

In regulatory parlance, the competitors want to "skim the cream," but this does not make their efforts illegitimate. It is also natural for incumbents to hoard the low-cost customers, and this does not make their retention efforts illegitimate. But if the hoarding is achieved through legalisms instead of better technology, the competitors' technologies will wither, their vitality drained by legacy networks using tariffs to soak up economic nourishment that should have flowed to better technology.

States regulate most telecom services through a tariff, which is a form of contract between the seller and buyer, where the regulator stands in place of the buyer. Service providers do not normally require every customer to sign an individual contract. The service provider files with the regulatory agency a tariff governing the relationship between the seller and all customers who fit the guidelines of the tariff. One residential services tariff can apply to all residential customers and one business tariff can apply to thousands of businesses. But one tariff can apply to just one customer. In this case, the tariff is a special deal between the service provider and the major customer.

Despite the Telecommunications Act's goal of promoting competition in telecom markets, the one-on-one tariff allows incumbents to lock-in major business customers by offering them tailored telecom services for an extended term at a discount from the "normal" price of the service. Once a customer subscribes to the services, that user can be terminated before the term expires if the customer pays the difference between the discount price and the normal price for the entire term.

For example, a customer may agree to take services at a 40% discount from the normal price for five years. If the subscriber wants to terminate in the third year, the payments due will be five years of revenue at the normal price less the revenue already contributed. This discount arrangement has several anticompetitive aspects. The longer the term's length, the longer the customer is denied the economic benefits of improved telecommunications technology. The competitor's "window of competitive opportunity" shrinks to a few days or weeks just prior to the term's expiration date, but the window may be even smaller if the one-on-one tariff includes right-of-first-refusal or automatic renewal options. The normal price for the service is not necessarily related to the service's cost, because incumbents operating under price-cap regulation can raise the normal price without having to offer supporting evidence to regulators. Finally, the termination charges dissuade a subscriber who might otherwise take service from an incumbent's competitor and are an indirect way of increasing either the competitor's cost of acquiring a new subscriber or the subscriber's cost of switching to a new provider.

The termination charges are reminiscent of Microsoft's past practice of charging computer manufacturers royalties on a per-processor basis. They had to pay for Microsoft's Windows operating system even if the manufacturer installed another system. Thus, the manufacturers were generally dissuaded from installing operating systems other than Windows. The exact same logic applies to one-on-one tariffs with termination fees. The U.S. Department of Justice Department pressured Microsoft into a consent decree in 1995 to end the company's royalty practice. That trail should be followed by responsible state and federal regulators to rein-in the termination charges before they negate the FCC's unbundling efforts, which assume that CLEC access to the loop is enough to create a competitive local market.

Curbing the one-on-one tariff won't be easy because in American jurisprudence, the contract is sacred. It supposedly represents the free choices of buyers and sellers and has the premise that neither party induces the other to accept terms that harm their respective self-interest. Applying this reasoning to telecom service leads to a rational conclusion that it is fine for the incumbents to skim all the cream and leave none for competitors. But if this were to happen, there would be no such thing as "competition." Individually beneficial decisions can have harmful cumulative effects.

The links between individual decisions, their aggregate impact, and cream skimming is analyzed in "The Tyranny of Small Decisions," an essay written in 1966 by Alfred E. Kahn. He is a long-recognized expert in regulation, the dean of expert regulatory witnesses for the incumbent local telephone companies, the former head of the now-defunct Civil Aeronautics Board in the Carter administration, and a professor emeritus at Cornell University.

Kahn wrote, "A market economy makes its major allocations decisions on the basis of a host of 'smaller' decisions...[But] the consumer can be victimized by the narrowness of the context in which he exercises his sovereignty...[I]f enough people vote for X, each time necessarily on the assumption that Y will continue, Y may, in fact, disappear..., a genuine deprivation that customers might willingly have paid something to avoid." He also commented on why it is legitimate for new competitors to focus their efforts on the incumbent's major customers: "The telephone company needs no artificial barriers against the entry of specialist firms seeking to take away its apparently more No competitor could survive on cream alone, unless the incumbent is inefficient ...or using outmoded technology."

Kahn's remark about outmoded technology was prescient. While fiber optics was still in the laboratory stage, he described a case that sounds like a fiber-optic competitor challenging a legacy network: "Suppose...some firm outside the Bell System found a new way to transmit telephone messages using the rays of the total unit costs less than...current rates. Would the incumbent company then deserve protection?...Whether by competition or by regulation the rates should be brought down to the total unit costs under the new technology." However, neither price cap regulation nor competition will bring prices down in local markets inundated by one-on-one tariffs-which allow prices to remain stable in the face of new technology.

This problem pervades telecom markets, so local incumbents will be hoisted on their own petard when they enter inter-LATA markets, because the same practice goes on there. Regulators ignore it because they accept the arguments made in the 1980s by such people as the University of Chicago's Richard Posner, now a federal judge, and William Baumol, the main author of "contestable market" theory, that an incumbent's market power is nullified if competitors have easy access to the incumbent's market. But this theory was deemed unrealistic long ago by George Shepard, an economist from the University of Massachusetts who wrote in 1983, "Entry occurs with the stroke of a pen rather than by the physical creation of the entrant's capacity....[B]ut this is too easy....[I]t merely transfers the actions to contracting wars....[T]he incumbent could set standing offers to beat all credible offers by entrants...rendering them not credible [competitors]." The chickens have come home to roost.

Stephen N. Brown writes on public policy in telecommunications. He can be contacted by e-mail at [email protected] or telephone: (615) 399-1239.