Progress Report:

Growth and Competition in

U.S. Telecommunications

1993-1998

February 8, 1999

The Council of Economic Advisers



EXECUTIVE SUMMARY

Since 1993 the U.S. telecommunications industry has prospered. Telecommunications markets in the United States have continued to open and firms have competed to meet new consumer demands, to build the infrastructure to support the growing information industry spurred by the Internet, and to provide the foundation for future innovations in communications. The benefits for the U.S. economy have been substantial:

The telecommunications sector has created hundreds of thousands of new jobs since 1993. The telephone services and equipment sectors, long areas of declining employment as technology increased productivity, are directly responsible for the net creation of approximately 200,000 new jobs in the past 5 years.

Hundreds of new firms have entered all sectors of the industry, with the number of publicly held telecommunications companies alone nearly doubling in the past 5 years. New competitors have been responsible for much of the growth in the local, long-distance, wireless, and equipment sectors.

New and incumbent firms have collectively invested tens of billions of dollars in facilities, services, and research and development, leading to increased network capacity, deployment of new technolgy, and roll-out of advanced communications services.

Output of services has increased and prices have declined industry-wide.

This progress has been supported by the Administration's long-standing commitment to make competition and regulatory flexibility the fundamental principles on which U.S. telecommunications policy is based. In 1993, when Vice President Gore announced those principles in the Administration's National Information Infrastructure agenda, there were predictions that the approach would lead to substantial industry growth. The above results bear those predictions out.

The benefits of a policy approach geared towards opening markets and promoting competition can be seen sector-by-sector in the telecommunications industry:

Long-distance telephone services: Growing competition in long-distance services has eroded AT&T's market share from its former monopoly level to about 50 percent. With this competition has come increasing availability of low-cost calling plans for a broad range of consumers. As a result, average revenue per minute earned by carriers has been declining steadily for several years and long-distance usage has increased substantially. Consumers will likely reap further benefits as competition grows in the long-distance market under the Telecommunications Act of 1996.

Local telephone services: Many new carriers have entered the wireline local services market since the 1996 Act, providing both switched voice and high-speed data services to customers. To date they have created more than 50,000 new jobs and attracted over 30 billion dollars worth of capital investment, not counting debt or private venture financing. Recent entrants, including resellers, have so far captured between 2 and 3 percent of the local services market measured by lines and about 5 percent of the market measured by revenues. The competitive emphasis to date has been on business rather than residential customers, due partly to underlying economic and regulatory factors. As competitors establish their businesses and expand their networks, and now that the Supreme Court has affirmed the FCC's broad authority to implement the 1996 Act's market-opening provisions, local competition for residential customers is likely to increase.

Wireless telephone service: Increased capacity and competition have led to fast growth of wireless services: over 60 million Americans now subscribe to mobile service; four times the number in 1993. Median prices per minute have fallen, depending on usage levels, between 30 and 40 percent for residential users and as much as 50 percent for business users. Wireless carriers directly created more than 100,000 new jobs from 1993 through 1998. Wireless service revenues have grown an average 24 percent annually since 1993, to $30 billion. Capital investment by the industry has reached a cumulative $50 billion.

Telecommunications equipment: The telecommunications equipment industry in the U.S. has grown substantially. Total revenues in 1998 are estimated at $120 billion, a three-fold increase since 1993. A growing proportion of manufacturing consists of innovative equipment for integrated voice and data communications over digital networks. Annual U.S. telecommunications equipment exports doubled from 1993 to 1998, to over $25 billion.

Telecommunications infrastructure and the information sector: The telecommunications industry provides the infrastructure for fast and reliable transport of information. With the surge in Internet usage in the past 5 years, the number of "hosts" for Internet sites grew from fewer than 3 million to over 30 million and electronic commerce has become a multi-billion dollar industry. Driven by the growing information industry, high-speed data services have spread as providers invest in facilities to provide customers with a variety of "broadband" options; deployment of high capacity fiber grew by at least 16 percent in 1997; and production of innovative data networking equipment has increased. Demand for additional lines has increased with data traffic, from about 9 million lines in 1993 to about 18 million lines in 1997.

In some of the above markets, such as long-distance, growth is the effect of more than a decade of competition. In others, like local telephone service, the regulatory and legislative changes that opened the market to entry occurred much more recently. While more remains to be done for entry to occur in parts of the local market, notably residential service, the lesson from markets with a longer history of entry is that, with time and opportunity, competition can grow and produce the expected benefits.



(Please note:  Charts in the following sections could not be reproduced)


INTRODUCTION



This report describes developments in the U.S. telecommunications market since 1993.(1) It presents an overview of the growth of the industry, discusses key developments in the long-distance, local, wireless, and equipment sectors, and describes the dramatic rise in use of the Internet and the increasingly interdependent relationship between the information and telecommunications industries. The goal of this report is not to examine the economic issues underlying specific regulatory proceedings, nor is the purpose to analyze whether particular refinements to current laws or regulations would be useful. It is instead to discuss overall trends and to assess the broad impact of the current regulatory framework.

The evidence reviewed demonstrates that the telecommunications industry has been a substantial part of the outstanding performance of the U.S. economy--now in the longest peacetime expansion in American history. Since 1993, the telecommunications industry has created hundreds of thousands of new jobs, seen entry by hundreds of new companies, made tens of billions of dollars of new investment in infrastructure and innovation, raised exports, and fostered a revolution in the scope of communications services available to consumers.

The growth of the American telecommunications industry has been supported by a flexible, competition-oriented approach to policy and regulation. The principles of market competition and regulatory flexibility are implemented in the Omnibus Budget Reconciliation Act of 1993, through which President Clinton signed into law authorization for auctions of spectrum for wireless communications; in the National Information Infrastructure (NII) initiative developed by the Administration in 1993 and overseen by Vice President Gore; and in provisions of the Telecommunications Act of 1996. They appear also in the Administration's initiatives to ensure the successful growth of electronic commerce and to keep the Internet, a key driver of demand for telecommunications infrastructure, free from economic regulation.

To be sure, there remain important challenges for telecommunications policy to address - for example, ensuring that competition develops further and more quickly in certain markets and that anti-consumer tactics like "slamming" and "cramming" are stopped. Moreover, innovation and change in a variety of markets, for example in the markets for satellite, cable, and fixed- wireless services, may alter the assumptions underlying some current regulations and require policies to adapt. But by any fair measure, the development of the telecommunications market in the United States must be considered a success. This success provides no basis for complacency, but neither do remaining challenges provide a reason to change the current regulatory approach. Instead, both are strong reasons to adhere more strongly to the underlying principle of open competition that is bringing great economic benefits to American workers, consumers, and businesses, and to make sure that competition has the opportunity to develop in markets where it so far has been unable to do so.
 
 

Policy Developments

Traditional market structure and regulation. For much of this century, most telecommunications service in the United States was provided by a single, regulated monopoly. Competition first arose in long-distance service. That market was fully opened to new entrants in 1984, when the Department of Justice's antitrust suit led to the break-up of the integrated Bell system into 7 separate local companies, the Regional Bell Operating Companies ("RBOCs" or "baby Bells") and one unaffiliated long-distance company, AT&T. Telecommunications markets nonetheless continued to be highly regulated. Local telephone service remained, for the most part, the province of monopolies overseen by state utilities commissions. The long-distance market became more competitive but, in order to ensure that it remained so, entry into the market was barred for the RBOCs because they controlled access to local networks and could therefore discriminate against rivals needing that access to originate or terminate long-distance calls. The nascent cellular industry started with two licenses in each service market being issued by the FCC, one to the incumbent local carrier and the other to an unaffiliated entrant. Partly due to regulatory limitations on available spectrum, the market remained a duopoly for several years.

Policy evolution. Recognizing that the telecommunications industry was changing at an increasingly rapid pace due to technological and market innovations, and that the regulatory framework needed to adapt to those changes, the Administration launched the National Information Infrastructure (NII) initiative in September 1993. To complement and advance the NII initiative, the Administration proposed in January 1994 a set of principles for overhauling the regulatory framework of telecommunications and fostering investment and competition. The NII initiative envisioned advanced networks that would make it easy and affordable to connect people to each other, to computers, and to a vast array of services and information resources. On the wireless side, the Omnibus Budget Reconciliation Act of 1993, signed by the President, authorized the FCC to increase competition in the wireless industry by auctioning major blocks of radio spectrum across the country.

Fundamental principles for regulatory reform. Along with the need for a modern, flexible regulatory framework, the Administration promoted from its earliest days the benefits of competition for both consumer choice and innovation. Vice President Gore thus set forth five fundamental principles to guide the study and formulation of legislative proposals for regulatory reform:
 

Encouraging private investment in information infrastructure;

Promoting and protecting competition;

Providing open access to advanced telecommunications networks for consumers and service providers;

Preserving and advancing universal service to avoid creating a society of information "haves" and "have nots"; and

Ensuring flexibility so that the newly-adopted regulatory framework can adapt to rapid technological and market changes in the telecommunications and information industries.

The Telecommunications Act of 1996. The principles of the NII initiative are reflected in many instances in the Telecommunications Act of 1996, which Congress passed with overwhelming bipartisan support. When President Clinton signed the Act into law on February 8, 1996, he called the legislation an important step in the Administration's commitment "to reform our telecommunications laws in a manner that leads to competition and private investment, promotes universal service and open access to information networks, and provides for flexible government regulation."The 1996 Act eliminated legal barriers to entry and further opened the door to local phone competition by requiring incumbent local telephone companies to interconnect and exchange traffic with new entrants into the market on non-discriminatory terms, to lease one or more parts of their networks ("unbundled network elements") to new entrants at cost-based prices, and to provide service at wholesale rates to new competitors so they could gain a foothold in the local market through resale to customers. The Supreme Court recently upheld the FCC's authority to implement many of the market-opening provisions of the Act after the scope of that authority was challenged by incumbent local carriers and certain states.

In addition to imposing market-opening obligations on incumbents, the 1996 Act withholds authority for the RBOCs to enter the long-distance services market until they have fully complied with those obligations. The RBOCs have been barred from that market since 1984, when an antitrust settlement caused their divestiture from AT&T. The 1996 Act lifts that restriction once the FCC finds that an RBOC has met certain market-opening requirements set forth in the statute, providing a further measure to achieve the Act's goal of opening the local market to competition.

The FCC's policy efforts since the Act have focused on implementation. Defining and restructuring universal services, reforming access charges, and establishing the rules under which incumbent local telephone companies can provide "advanced" services over their networks are examples of issues on which the Commission has been working. Further policy developments will follow as markets continue to change in response to the 1996 Act and to new investment and technological innovation.

Economic Growth and Competition in Telecommunications Markets

Revenue growth and contribution to the national economy. At the time the Administration announced the NII initiative in 1993, it was estimated that industries related to the NII would create $300 billion in new sales for the telecommunications industry and contribute a comparable amount to GNP by 2007. These levels are already being achieved and even surpassed: Communications services and equipment companies had revenues of about $250 billion in 1993, which grew to $408 billion in 1998 (Chart 1). Telecommunications services contributed about $25 billion to GDP growth from 1996 to 1997, and increased their share of GDP by more than 20 percent.(2)

Overall job creation. The telecommunications services and equipment sectors are directly responsible for the net creation of, conservatively, about 200,000 new jobs since 1993 (Chart 2).(3) This increase is extremely significant: prior to 1993, telecommunications employment was decreasing, even as the production of telecommunications services was expanding. For example, from 1981 to 1992, the number of phone lines--"local loops"-- in the United States increased by nearly 40 million, and the amount of long-distance calling more than doubled.(4) But over that same time period, the number of workers in the U.S. telecommunications services industry fell by 200,000.(5) Indeed, labor productivity in the telecommunications industry--measured as output per hour--increased by 80 percent from 1981 to 1992, reducing the number of workers needed even as business grew rapidly.(6) Labor productivity in telecommunications has continued to grow at least as fast since 1992.(7) But lower prices, new and innovative services, dramatic growth of wireless communications, and new demand for services and infrastructure from the information sector have caused the growth of the telecommunications industry to outpace productivity increases and create large numbers of new jobs.

Telecommunications firms have been particularly important in providing crucial inputs to other industries, thereby contributing to the progress and growth of those sectors. By providing the advanced infrastructure and services essential to data processors and information providers, the telecommunications industry has contributed to the creation of an additional 600,000 new jobs since 1993 in data services, whose growth depends significantly on communications infrastructure (Chart 2).(8) That figure does not count indirect employment effects in the software and computer hardware industries, or in the many other economic sectors that have become increasingly reliant on telecommunications and information technology.(9)

Entry by new firms. The structure of the telecommunications industry today is radically different from that of 15 years ago. Numerous firms have entered each sector of the telecommunications market, with the number of public telecommunications companies swelling from under 100 in 1984 to over 200 in 1993 and surging to just under 400 in 1997. In critical sectors like local telephone service, the majority of entrants are private companies not counted in the above figures. The Association for Local Telephone Services (ALTS) lists 145 private companies in the local exchange market alone. Consolidation and acquisitions keep the number of companies in flux, but market data show that many of the fastest growing and most successful firms in the industry are unrelated to AT&T, its Regional Bell Operating Company progeny, or any of their subsequent spin-offs. In the long-distance, local, and equipment sectors of the telecommunications market, small, recent entrants have outpaced larger and more established firms in their rate of growth of both market capitalization and revenue.

Competition and market value. When concentrated or monopoly industries become competitive, economic theory suggests that, unless the market grows, profits decline as rival firms offer lower prices and transfer more value to consumers. What is good for customers may be viewed differently by shareholders. It is thus indicative of growth and innovation in the telecommunications market that, despite major changes in the regulatory environment, increased competition, lower prices, and some predictions to the contrary, the market value of public telecommunications firms since 1993 has kept pace with the soaring U.S. stock market and increased by over $800 billion--more than doubling in size (Chart 3). The many private companies have created substantial, additional value and investment. More than half of this growth is from companies that did not exist prior to the breakup of AT&T's integrated monopoly in 1984.(10)

New infrastructure. The growth of the telecommunications industry has led to construction of more advanced infrastructure. The conversion of the wireless industry to digital technology and expanded use of fiber optic cable in wireline systems are two examples. FCC figures show that from 1993 through 1997, fiber deployment increased from 2.3 million to 3.4 million miles in long-distance networks, from 6.6 million to 12.2 million miles in incumbent local telephone networks, and from 0.2 million to 1.8 million miles in competitive local exchange networks.(11) Fiber mileage overall increased an estimated 16 percent in 1997 alone. The above figures are estimates based on incomplete data. Actual fiber capacity by the end of 1998 was almost certainly much higher. Moreover, the above data do not include the 800,000 fiber miles in place by the end of 1998 in systems financed by the Rural Utilities Service of the United States Department of Agriculture, or the fiber systems installed by others such as electric utility companies or state governments.(12)

Infrastructure that will advance the telecommunication sector, and the consumers and industries that increasingly rely on it, continues to develop in circuit-switched telephone networks as well as in data networks, satellite operations, and cable systems. The current emphasis is on expanding the broadband connections available to households and businesses. New entrants into all of those sectors are constructing new facilities and upgrading existing ones, and promise to provide an increasing range of services on more competitive terms for consumers.

Long-Distance Telephony

Long-distance telephone service was for decades a monopoly of AT&T. That monopoly was attacked at the margins in the 1970s and early 1980s and more fully after the Department of Justice's antitrust suit successfully opened the market by breaking up AT&T in 1984. While AT&T's share of long-distance revenues at first eroded slowly against competition by MCI and Sprint, it has declined from over 90 percent in 1984 to under 50 percent today.(13)

Since the 1980's, increasing numbers of residential and business customers have been offered subscription plans and incentive programs that lower their actual long-distance prices below the basic tariff rates, or posted prices. While the tariff rates fell steadily through the 1980s and then, starting in 1991, began to rise slightly, the proliferation of discount options has meant that the basic tariff rate alone overstates actual prices paid in most cases. With incentive programs and low-rate plans available not only to high volume callers, but also to customers whose monthly long-distance bills average as little as $10, it is extremely difficult to calculate how much particular customers are paying per minute of long-distance use. But one indication of actual prices is the FCC's data on average revenue collected by long-distance companies per minute of usage. By this measure, effective rates have declined steadily over the last five years (Chart 4). Long-distance usage, meanwhile, went from about 370 billion minutes in 1993 to 500 billion minutes in 1997 (Chart 5).(14) This increase is partly a function of the availability of lower rates, but also of an outward shift in long-distance demand due to increased transport of data and information.

The combination of lower long-distance prices and increased long-distance usage has been driven by competition. In the past five years, many new firms have entered the long-distance market both as resellers and by building their own facilities. According to FCC data, the numerous companies with tiny individual market shares raised their collective share by 7.5 percentage points--from 12.3 to 19.8 percent of the market--from 1993 to 1997, and together have made the largest market-share gains in the long-distance marekt.(15) That small firms have become more competitively significant both as a group and individually is indicated by the expanding list of firms whose individual shares are reported by the FCC. New carriers have continued to bring additional competition to the long-distance market, in some cases deploying substantial new facilities. There has also been entry into the market by 1010-xxx "dial-around" services and consumer substitution of the Internet for increasing amounts of data and voice traffic. Recent data show a dip in long-distance prices that corresponds to this entry.

The substantial competitive advances in the long-distance market do not preclude benefits from further entry. In addition to the possibility of even lower rates through competitive erosion of existing profit margins, one of the principal benefits of additional competition could arise from more widespread offerings of bundled local and long-distance services. Most observers have concluded that such bundled offerings would be attractive to consumers--particularly residential consumers--and may create significant cost-saving opportunities (from joint marketing, billing, etc.) for carriers that would lead to lower prices. Greater availability of such bundled offerings depends on the abilities both of long-distance carriers to be effective providers of local service, and of the Bell companies and other local carriers to offer long-distance service. Thus, completion of the local market-opening process required by the 1996 Act, which will enable such cross-entry to occur, can yield additional consumer benefits.

Local Telephone Service

After the 1984 divestiture of AT&T, local telephone service remained a franchise monopoly throughout the United States. The regional "baby Bells" and GTE were, and remain, the largest local-service providers, while over one thousand independent companies and cooperatives serve small, primarily rural, territories. The regulatory barriers to entry into the local market were substantial and, for the most part, within the jurisdiction of state public utilities commissions. A variety of justifications were advanced for local monopolies: the economics of "natural monopoly," preserving geographical rate averaging or other cross-subsidies that support universal-service goals, and ensuring timely network upgrades and extensions. Competition was eventually allowed in the provision of enhanced services and access to the long-distance network, but not generally in switched, local voice service.

The 1996 Act radically changed that regulatory environment by pre-empting and prohibiting regulations that protect monopolies over local telephone service. The Act thus dismantled a legal and administrative structure that had evolved over decades and replaced it with a fundamental rule: the local telephone market must be open to competition. The Act pushes this principle beyond the regulatory agencies to the incumbent local exchange carriers ("ILECs") themselves. It requires incumbent local companies to open their networks so competitors can "interconnect" (i.e. exchange traffic) with incumbent networks and lease "elements" of the incumbent networks (facilities like switches and customer lines) that the entrants lack.

Competitive entry since the Act has focused principally on full-service, local telephony for urban business customers. Residential local service has seen some competitive entry but has not developed in a manner comparable to business service. The market opening provisions of the 1996 Act have also spurred entry by firms providing high-speed data services to local exchange customers over unbundled loops leased from the incumbent carriers.

Progress by the CLECs: Competitive local exchange companies ("CLECs") have invested billions of dollars and have come to employ over 50,000 workers since 1992.(16) Several of these companies started as competitive access providers that offered business customers bypass of the local exchange and connection to the long-distance network at lower prices. Some CLECs began to acquire the numbering codes necessary to operate competing local switches as early as mid-1994,(17) but little competing service actually existed. Since the 1996 Act, when CLECs began to acquire numbering codes more rapidly and, in addition, were able to enter the market for switched, local voice service through resale and use of the ILEC's unbundled network elements, they have captured between 2 and 3 percent of local lines from the incumbents (Chart 6). Because competitors have focused on serving the largest and most profitable customers first, the business they have won represents about 5 percent of the local services market measured by revenues (Chart 7).(18) Current data show local telephone revenues overall to be growing about 5 percent annually, driven by the demand for data and Internet service and for "vertical features" like voice mail and caller ID. The shares the CLECs are gaining are thus of an expanding market.

Recent data show the publicly traded CLECs to be gaining between 600,000 and 700,000 customer lines per quarter, most of them business customers (Chart 8).(19) It would take the CLECs about ten years to capture half the 60 million business lines now in service if they continue to add lines at the current pace. Of course, both the number of business lines and the rate of market growth of the CLECs are likely to change, making the actual rate of market share change uncertain. But as a benchmark, it took more than a dozen years after the 1984 divestiture for long-distance competitors to gain a 50 percent share of market revenues, and their shares of pre-subscribed lines and long-distance access minutes has not yet reached that level.(20)

More than 70 percent of lines served by CLECs are through resale of the incumbents' services or through combination of the ILECs' unbundled network elements with the CLECs' own facilities.(21) Competition by new entrants serving customers mostly on their own networks--"facilities-based" competition--accounts for the remainder. However, it is estimated that more than one third of the lines added by the CLECs in the third quarter of 1998 were on the CLECs' own networks. This very slightly raised the proportion of total CLEC lines that are independent of the ILECs' facilities to 27 percent, and suggests that facilities-based competition for local service is becoming more common.(22) The growth of facilities-based competition relative to resale is also documented by the Telecommunications Resellers Association, which reports that, from 1995 to 1998, the proportion of its members that owned or leased facilities (as opposed to competing through pure resale) increased from 34 percent to 54 percent.(23) The FCC estimates that the number of unbundled loops leased by CLECs from large incumbents in order to provide partially facilities-based service increased by 10 percent in the third quarter of 1998.

The number of switches owned by CLECs grew from 65 before the Act to nearly 700 by the end of 1998.(24) As new entrants continue to build out their networks, the relative growth of facilities-based service will likely accelerate. Several sources of data show the CLECs to be building out their fiber networks at a fast clip, although the data are sketchy and incomplete. Merrill Lynch estimates from its survey of public CLECs that those companies added over 40,000 route miles of fiber to their networks in each of the first three quarters of 1998, and that the rate of deployment was increasing through that period.(25) FCC data show the amount of fiber deployed by CLECs to have tripled from 1993 to 1997, with particularly rapid deployment from 1994 to 1997.(26)

The marketplace clearly expects local competitors to flourish. Although CLECs are still in the early stages of accumulating market share, and only one has so far posted a profit, they have created nearly 20 percent of the growth in local telecommunications market value since 1993.(27) The market capitalization of CLECs has gone from almost nothing to over $30 billion since 1993.(28) The value of the numerous privately held CLECs is not captured by the above figure. Employment by competitive local service companies has also grown dramatically since the 1996 Act. Data from 23 small, local entrants that voluntarily reported employment figures to the Association for Local Telephone Services (ALTS) show employment increasing by over 100 percent in 1998 alone--from roughly 9,000 jobs in January 1998 to over 18,000 jobs at year's end in the sample companies alone. The ALTS sample did not include employment data for large companies like MCI WorldCom, AT&T, Sprint or others that have entered the local market, nor does it account for the vast bulk of CLECs. The growth rate, however, is indicative of the investment being committed to local competition. CLECs are plying their trade in all of the top 100 urban markets in the United States, and in 250 smaller business trading areas as well.(29)

Residential versus business competition. Competition in the provision of local telecommunications services to residential customers has proceeded more slowly and tentatively than competition to serve business customers. Some CLECs target business customers exclusively. Comptel, an industry association representing CLECs, recently surveyed its members about local competition. Twelve of seventeen respondents reported providing residential service in at least one state. Overall, of the roughly 5 million lines estimated to be served by CLECs, less than one third probably belong to residential customers. The United States Telephone Association, the industry association for incumbent local carriers, reports that about 1.3 million residential lines are being resold by CLECs.(30) The FCC makes a similar estimate of 1.2 million lines.(31)

Resale remains the primary means by which CLECs are serving residential customers. The Telecommunications Resellers Association (TRA) represents numerous competitors, 175 of which provide local phone services through a combination of resale and deployment of their own facilities. Of the customers served by TRA's members, 21 percent are reported to be residential. And 94 percent of the residential business is through pure resale rather than through use of facilities that the CLECs either own or lease from the incumbent.(32) The FCC finds that, while CLECs serve 1.2 million residential lines through resale, they serve about 260,000 customers through a combination of their own facilities and unbundled network elements leased from the ILECs.(33) Fully facilities-based competition by CLECs for residential customers, at least on a broad scale, seems distant. Such competing facilities may come sooner from cable entrants into local telephony. AT&T has made acquisitions and formed a joint venture to provide telephone service over cable systems that pass over 40 percent of American households. Other cable systems have slowly been upgrading their networks and marketing local phone service to their cable customers.

There are several possible explanations for why competition has been slower to develop in the residential local service market than in the business market. Some parties point to problems of compliance with the 1996 Act--the FCC has not yet found any of the incumbent carriers to have satisfied all of the Act's market-opening requirements. But, the pace of residential competition is also strongly affected by underlying economic factors. The economics of residential local service--with its regulated rates and comparatively lower sales of profitable, vertical services--arguably do not make pursuit of the average residential customer as interesting a business prospect when there is lower-hanging fruit in the business market.

Regulation keeps rates for residential local service low, and the revenues gained from access charges that long-distance carriers pay to local networks are generally lower for residential than for business customers. But the costs of providing a phone line are about the same for residential and business customers, making the latter a source of higher profit margins. A CLEC incurring the fixed costs of entry will therefore recoup its investment more quickly by focusing on the business sector. Moreover, marketing costs per line are probably lower for business customers, which often have multiple lines, than for residential customers that typically have one, and at most two or three, lines. A reflection of the relative desirability of business customers, and of the greater geographic concentration of business customers, is that the switching centers in which CLECs have collocation arrangements serve 50 percent of ILEC business lines, but only 35 percent of residential lines. Moreover, those switching centers serve at least 57 percent of the incumbents' high-capacity lines, which are connected to the largest and most profitable business and government customers.(34)

Regulation also produces below-cost rates for local service in areas where the costs of providing service are high, and above-cost rates for local service in areas where the costs of providing service are low. In other words, revenues from above-cost rates implicitly subsidize below-cost rates. Entrants thus have artificial incentives to provide service to customers paying above-cost prices (e.g. business customers and urban residential customers) and artificial disincentives to serve those customers paying below-cost prices (e.g. rural customers). The FCC and state regulators are working to restructure the current system of rates for local telephone service in a way that both preserves universal service and makes serving residential and rural customers more attractive for competitors. But until regulation of residential and rural rates are made competitively neutral, entry incentives will remain skewed.

The residential market remains an area in which competition needs to develop further to meet the goals of the 1996 Act. But developments in local competition so far are not necessarily as limited or unpromising as some portray them to be. History indicates that roll-out takes time and generally starts, for sound economic reasons, with higher-revenue customers. The construction of the original Bell System itself is a lesson in the move from commercial centers to more rural areas. And Bell was merely repeating a strategy followed decades before by Western Union in building out its telegraph network. MCI's entry into the long-distance market similarly started with private business service, went to public business service, and eventually to residential offerings.

The aggressive entry by CLECs into the business market, and their construction of facilities for both voice and data, are likely to have benefits for residential customers over time. For example, CLECs have been constructing urban fiber networks that pass not only businesses, but apartment houses as well. Once the infrastructure is in place, serving residential customers in "multiple dwelling units" becomes easier and may entail only incremental cost. As the most profitable customers provide the CLECs with the revenue necessary for effective entry into the local market, competitors will be able to expand service oferrings to customers from which they earn less return.

Because of the long institutional history of local monopoly and the economic complexity of entry into the local residential market, the uneven development of competition does not in itself show that the 1996 Act's market-opening provisions are a failure or should be changed. Indeed, the developments in the business market suggest otherwise. To ensure that the potential for residential benefits is realized, continued application of the proven, competitive principles of the Act is the course better supported by the economic evidence.

Data CLECs and broadband competition. A developing area of local competition has been in the market for high-speed data services. Numerous companies have taken advantage of the 1996 Act to lease customer lines ("loops") and space in the incumbents' switching centers ("collocation" space) in order to offer customers digital subscriber line (DSL) service, primarily for high-speed access to the Internet. DSL technology uses special modems to transmit digital information over existing copper lines. Most of the data CLECs are still small, privately held companies. Although there is little available data on DSL deployment, it is estimated that about 30,000 lines are so far being served. By comparison, about ten times that number of customers receive broadband service from cable companies over "cable modems."(35) But competition in data services over the telephone network shows promise. Data CLECs have invested heavily in facilities, pushed DSL prices down, and created thousands of new jobs in the services and manufacturing sectors. Several competitive DSL providers have entered multiple markets in which they compete against each other, the ILECs, and cable modem providers. For example, competition among broadband service providers in the San Francisco area has recently pushed DSL service prices down to about $40 per month.

Competition in DSL service faces several challenges as it grows. First, DSL must overcome certain technological impediments. Transmission via DSL is generally most effective for customers located a short distance, for example about three miles, from the central switching office. Performance of DSL transmission declines with loop length, but varies also with condition of the loop and the quality of equipment attached to the loop. Technological advances are starting to provide improvements, but for now DSL remains an option primarily in densely populated areas where loops are short.

A second challenge for DSL providers, like other CLECs, is getting collocation everywhere they need it, and therefore in gaining access to some customers lines. As more competitors have entered the market and sought collocation in central offices serving the most desirable regions, entrants have reported difficulty in negotiating collocation arrangements. Technical issues such as whether collocation at remote terminals outside of central offices is necessary to serve customers who do not have a direct copper line to the central office, is another unresolved problem for CLECs. These challenges are intensified by the fact that incumbent local service providers offer both DSL service themselves and control inputs--notably loops and collocation space--needed by their DSL competitors. Nonetheless, the DSL market is growing and, if the above challenges can be met, data CLECs could grow into a substantial competitive presence in a greater number of markets and offer a broader range of services than is the case today.

Wireless Telephone Service

The wireless telephone industry has experienced remarkable growth in the past 5 years. From 1993 to 1998, the number of Americans subscribing to cellular service grew from about 16 million to over 60 million (Chart 9).(36) Policies that set the stage for increased competition in the wireless market and fostered investment in advanced digital technology directly contributed to this growth.

The FCC assigned the first licenses to use radio spectrum for cellular telephone service in 1983, introducing competition through a "duopoly rule" under which one license in each market was given to the incumbent local telephone provider and another to an unaffiliated competitor. By June 1985, cellular companies altogether had just over 200,000 subscribers, 600 "cell sites" (each site contains the transmission equipment that serves a local cell), and 1,700 employees.(37) In June 1995, subscribership had climbed to 28 million, a total of 20,000 cell sites were operative, and the number of people employed by wireless service companies was 61,000.(38)

In 1995, as authorized by the President and Congress in the Omnibus Budget Reconciliation Act of 1993, the FCC held the first auctions for broadband spectrum to be used for digital "personal communications services" (PCS), creating new wireless licensees in U.S. markets. As the successful bidders entered the market, and as subsequent licenses were auctioned, the duopoly market structure gave way to full-fledged competition among multiple providers. By the middle of 1998, there were nearly 61 million cellular subscribers and over 57,000 cell sites, and by end of 1998, over 160,000 Americans were holding jobs with wireless telephone companies (Charts 9, 10, and 11).(39) The average monthly bill for wireless telephone service fell by more than half from its level a decade earlier, probably reflecting both declining prices and changes in average monthly usage as more individual, as opposed to business, customers used wireless service.(40)

Today, more than 200 million Americans, or over 80 percent of the population, live in wireless service areas with at least 1 new competitor to the 2 original cellular systems, and more than half of all Americans live in areas with at least 3 new competitors.(41) This new competition, as well as increased investment in new technology, has caused prices to plummet while increasing the variety of available calling plans. Although reliable data on revenues per minute are unavailable, existing price and billing data indicate that wireless telephony is becoming ever more affordable. One study finds that in 1997, median prices per minute--what the typical user pays--fell as much as 30 to 40 percent for residential users and 30 to 50 percent for business users, due primarily to new PCS competition.(42) As mentioned, the average monthly bill for mobile customers has fallen by more than half in the last decade.(43)

Wireless telephony (cellular, PCS, and ESMR) is now a nearly $30 billion industry, as measured by service revenues, growing an average 24 percent a year since 1993.(44) Capital investment, a leading indicator of future industry growth, has now grown to a cumulative $50 billion (Chart 12).(45) Extraordinary growth in subscribership is the cause: more than 60 million Americans, or more than 1 in 4 American adults, now subscribe to a mobile service. That is nearly 60 percent higher than in 1996 and five times the number in 1993.

There is anecdotal evidence that wireless telephone service is beginning to substitute on the margins for traditional (wireline) telephone service; and it may do so increasingly as technology improves, competition and subscribership increase, and prices fall. Wireless companies have excess capacity on their networks and have been able to offer packages that provide a maximum number of minutes--whether local or long-distance, and from anywhere in the country--for a fixed price. In the second half of 1998, prices for these packages fell as low as $50 for 500 "anytime, anywhere" minutes. Such low-priced packages have the possibility of making wireless service an alternative to wireline service for some users, particularly those who travel a lot or desire an additional line from home.

In addition to the main wireless telephone technologies of cellular, PCS, and ESMR discussed above, wireless communications also encompass such services as paging, SMR, and fixed point-to-point, as well as such new services as fixed wireless local loop and Third Generation mobile services. These services could have a profound effect on growth and competition in telecommunications, not just in the wireless market, but in the local, long-distance, and advanced services markets as well.

Further challenges remain for the wireless industry. As Americans increasingly demand information services and mobile access to those services, data traffic will become an increasing component of wireless telephony. As wireless use grows and services expand, technologies to manage increased traffic demands will need to be developed. But the success of the industry so far in innovating and growing to the benefit of American consumers leaves little doubt that wireless communications will be a central and growing part of telecommunications in the future.

Telecommunications Equipment

The telecommunications equipment industry in the U.S. has grown substantially. Total production in 1997 topped $70 billion and is estimated to have reached $120 billion in 1998, a growth of $80 billion since 1993 (Chart 13). New service markets created by wireless auctions, the 1996 Act, and the Internet have created a large demand for innovative telecommunications equipment. The many new entrants into equipment design and manufacturing have created thousands of jobs, invested billions in producing novel solutions to technical challenges faced by new entrants and incumbents alike in providing new services, and doubled U.S. exports of telecommunications equipment from about $13 billion in 1993 to over $25 billion in 1997.(46)

There are now more than 100 publicly traded companies that list telecommunications equipment as their primary line of business. Nearly 50 additional public companies list their primary line of business as data networking equipment. The joint market capitalization of traditional telecommunications equipment manufacturers and data networking equipment makers has more than tripled since 1993 (Chart 14). Again, numerous private companies add economic value that is not captured by the market capitalization data. The telecommunications equipment market as a whole is responsible for about one-third of the value created in the telecommunications market in recent years, with data networking equipment companies growing faster than traditional equipment companies since 1994.

The growth of data networking companies reflects the shifting demands of telecommunications consumers away from conventional voice telephony and toward fast and reliable data transport. Digitization is requiring systems to provide integrated voice and data services, and competition among conventional telecommunications equipment manufacturers and newer data network equipment makers is leading to research and development along several promising paths, both wireless and wireline.

The telecommunications equipment industry will play a crucial role in solving the myriad technical problems faced by new communications service providers, whether they be cable systems, data CLECs, or full-service CLECs seeking to build out their own facilities. The equipment industry in the United States also faces substantial global competition, particularly in the area of mobile communications, and U.S. policy is working through appropriate channels to prevent harm to American manufacturers from the technical standards adopted in various international markets.

The Internet

The pace of technological advance, the importance of forward-looking infrastructure, and the growing desire for information are all manifest in the rapid growth of the Internet and its associated industries. This relatively young sector of the U.S. economy has been boosted by the successful confluence of a market-oriented and non-regulatory government policy, private investment and innovation, and the public's growing demand for information services.(47) Regulatory forbearance and policies to encourage usage, as well as continuing investment in information infrastructure, have made possible unprecedented growth in both the development and adoption of this communications medium. For example, the Administration has successfully opposed taxation on Internet usage: the Internet Tax Freedom Act creates a 3-year moratorium on new taxes for electronic commerce, and the World Trade Organization has agreed to place a moratorium on customs duties for e-commerce. The Administration has also supported protection of intellectual property rights in the digital environment and has worked to establish a legal framework for electronic contracting. Furthermore, the Next Generation Internet Research Act authorizes an initiative to provide universities with the most advanced connections to the Internet and to support long-term research on Internet technologies.

The Internet's evolution from a government-sponsored research project to a global network that connects individuals, businesses, and institutions of all kinds has been propelled by increasing computing power at falling prices. The digitization of information has blurred the lines between data, video, and voice, with all these types available for transmission at ever lower cost. The cost of transmitting one bit of data over a kilometer of fiber optic cable fell by three orders of magnitude between the mid-1970s and the early 1990s.(48) The cost of processing one million instructions per second (mips) was $480 in 1978. By 1995, processing costs had tumbled to $4 per mips.(49) And the cost of information processing continues to plummet, increasing the capability of the information industry and expanding the demand for information services.

Notwithstanding the technical advances mentioned above, the recent growth trajectory of the Internet would not have been possible without the grid of telephone lines, cables, optic fibers, signal processing and routing equipment that forms the "backbone" of the U.S. telecommunications infrastructure. The increasing public demand for--and provision of--fast and ready information has driven this "backbone" industry, motivating tremendous private investment and market capitalization as well as job creation. The growing demand for carrying capacity, or "bandwidth," has pushed the roll-out of yet more physical equipment and wiring, as well as the deployment of such technologies as cable modems, ISDN lines, DSL services, and new methods of digital compression.

Investment in high-capacity fiber by telecommunications systems has also grown rapidly to meet new infrastructure demands. The number of "fiber miles," calculated by multiplying the number of miles of sheathed fiber times the number of fibers in the sheathed bundle, is one measure of system capacity. As mentioned previously, the number of such fiber miles constructed by telecommunications carriers in the United States grew by about 16 percent in 1997 according to FCC estimates.(50) On the consumer end, increasing numbers of American households are purchasing additional telephone lines. Although some of these lines are probably used mostly for voice service, many are used for dedicated data lines. The number of households with additional lines grew from 8.8 million in 1993 (9.4 percent of residences) to 15.7 million in 1996 (16.5 percent of residences).(51) Those numbers have most likely grown sharply since the end of 1997 with increased use of the Internet by American consumers. Co-axial networks used by cable television systems, which increasingly now offer Internet access, are another major source of information infrastructure that will be important for bringing broadband access to residential customers.

The equipment industry has also been driven by the need for more advanced information transport. Companies engaged in manufacturing equipment for data networks are developing the advanced electronics for broadband transmission and routing of digital material--whether voice, video, or data--that innovative service providers are using to construct the networks that link users to information on the Internet and other sources.

And such advanced links are increasingly in demand. Altogether, over 35 million Internet "hosts"--computers that store sources of information on the Internet--were active world-wide by early 1998, up from 20 million only six months earlier and from fewer than 3 million in 1993 (See Chart 15). Thanks to tremendous investment in infrastructure, the United States ranks far above Japan, Germany, and the United Kingdom in public participation in the Internet, as measured by the number of hosts per capita.(52) Only Finland has a higher concentration than the U.S. In 1993, there was roughly 1 Internet host in the United States for every 200 Americans. By 1997, the ratio had changed ten-fold, to 1 host for every 20 people--about 1 Internet host for every 4 American adults who use the Internet.(53) In the two years between 1995 and 1997, the number of people in the United States who used the Internet grew from about 28 million to over 73 million, or about one in four people.(54) This year, nearly one in three American adults is expected to be "online." The latest Pew Center survey finds that the total number of American Internet users today is over 80 million (See Chart 16).

Recent data also show that Internet use is reaching a broader spectrum of society. In 1995 the average household income of an Internet user was over $50,000. The latest Pew Center survey shows that the fastest growing groups of new Internet users are those with much lower income and educational levels than in the past. The survey finds that 23 percent of new users have annual household incomes below $30,000--which is below median household income in the U.S.--and that 40 percent of new users never attended college.(55) As use expands to all economic segments of society, so too will the range of services and uses available through the Internet.

Challenges nonetheless remain. There is evidence of a "digital divide" whereby some racial and ethnic groups in the United States use the Internet disproportionately less than others. The "e-rate" program for wiring schools and public libraries, created under the Telecommunications Act of 1996, will be an important means of increasing diffusion of Internet use and ensuring that access to information is widely available. To date, the e-rate program has disbursed over $750 million, with the goal of connecting up to 40,000 American public schools and 7,000 libraries to the Internet. Such policies ensure that an increasing spectrum of Americans will grow up with the skills to participate in an increasingly information-driven economy.

The broad reach of the Internet has made it suitable for an increasing variety of applications. "Distance learning" and telemedicine, for example, are already flourishing. Many businesses see a future in online transactions, or "e-commerce." The volume of retail sales over the Internet more than doubled between 1997 and 1998 and electronic commerce as a whole is forecast to reach $300 billion by 2002.(56) At the same time, widespread and growing public participation in this medium heralds new possibilities for the dissemination of public interest information, whether political discourse, community news, health resources, or scientific research. The telecommunications system is the foundation upon which these possibilities will develop.

Conclusions and Future Challenges

Competition and innovation have been vital catalysts for the growth of the U.S. telecommunications industry since 1993. Both of those forces have benefitted from a transformed regulatory approach that opens markets and rewards deployment of new services and technologies. In each of the market sectors examined, the path to increased output and lower prices has been the implementation of market opening policies, followed by investment, innovation, and competition. Fiber optics in long-distance networks, digital networks for wireless telephony, advanced services in the local network, and the equipment to support them, have all followed from the opening of those respective markets to competition. As a result, consumers pay less for larger amounts of long-distance service, wireless subscribership has soared as wireless rates have moved closer to those for conventional phone service, and households and businesses are finding the prices of high-speed, advanced services within reach as the services themselves become increasingly available.

While progress in telecommunications has been excellent, challenges remain and will continue to arise as technology and markets change. In the near term, ensuring that local markets continue to open, and that regulatory distortions on competitive incentives in those markets diminish, will be important. Moreover, unless the current system of rate averaging is restructured, the equitable goals of universal service policy--availability of essential services on fair terms for poor as well as rich, rural as well as urban--will be more difficult to achieve in an increasingly competitive telecommunications market. Specific competition issues like the pricing of interconnection and unbundled network elements, and the conditions on which ILECs may participate in the advanced services market, present challenges of opening markets while preserving efficient incentives to invest in and deploy new services, facilities, and R&D.

Although this report addresses the U.S. market only, there are also challenges on the international front of importance to American telecommunications consumers. The increasing volume of information and communications that flow globally make international telecommunications infrastructure and interconnection vital to businesses, institutions and other consumers. The FCC, the U.S. Trade Representative, the State Department, and the Department of Commerce have all worked to obtain fair terms for U.S. carriers that need access to networks in foreign markets and to open those markets to competition. Much progress has been made and telecommunications markets in many areas of the world have moved from a structure of state-sponsored monopoly to open competition. It is important that bottlenecks that impose discriminatory terms on new competitors in global communications do not develop or persist at our borders. The infrastructure investment that has increased capacity, lowered prices, and supported the information economy domestically will also benefit the growth of electronic commerce and other information-intensive sectors world-wide. Insuring that the same competitive incentives that have developed domestically also develop for investment in facilities between the United States and other countries, and within other countries themselves, will speed the arrival of those benefits.

Finally, as innovative services and technologies affect the structure of the telecommunications market, telecommunications policy will more effectively serve the public interest if it retains sufficient flexibility to change when regulatory assumptions no longer hold. The changes that innovative systems will bring to the telecommunications market are hard to predict. New kinds of data networks, Internet-based alternatives for voice traffic, and important changes in the scope and competitive structure of the satellite industry are just a few examples of current developments. It will become increasingly important to ensure that regulation is technologically neutral, and that competition is not handicapped by disparities in the regulation of different systems that, through convergence, have come to provide the same services. The lesson from the telecommunications industry over the past 5 years is that consumers and the American economy will continue to benefit as competition has the opportunity to take hold in all markets.



ENDNOTES

1. This report focuses on the telephone industry, which includes related carrier services like data transport. It does not address cable, broadcast, satellites, or other mass media services.

2. Total telecommunications revenues are the sum of telecommunications equipment sales reported by MMTA and telephone communications services revenues reported by the Census, projected to year-end 1998. U.S. Census Bureau. 1998. Annual Communications Services Survey. Also, MultiMedia Telecommunications Association. 1998. 1998 MultiMedia Telecommunications Market Review and Forecast.

3. Bureau of Labor Statistics (BLS). 1999. National Employment, Hours, and Earnings. Hereafter, "BLS."

4. Federal Communications Commission, Industry Analysis Division. 1998. Trends in Telephone Service. pp. 63, 97. Hereafter, "FCC. Trends in Telephone Service."

5. BLS.

6. FCC. Trends in Telephone Service. p. 19.

7. FCC. Trends in Telephone Service. p. 19.

8. BLS. Data for employment in the SIC category of "computer services and data processing," excluding the subcategories of pre-packaged software and computer repair and servicing.

9. The number of jobs that would not exist today without the growth of the telecommunications industry is likely much higher, although hard to estimate with precision. An example of the broader "ripple effect" can be seen in data the Cellular Telephone Industry Association has compiled on employment effects of the wireless industry. Beyond the more than 130,000 jobs created directly by wireless carriers, as of the end of 1998 there are an estimated 260,000 sales and distribution jobs, 45,000 manufacturing jobs, and over 600,000 support service, construction and product development jobs related to wireless. Such multiplier effects exist in all sectors of the telecommunications industry.

10. Calculated using Compustat data.

11. Federal Communications Commission. 1998. FCC Fiber Deployment Data - End of Year 1997.

12. United States Department of Agriculture. 1998. 1997 Statistical Report Telecommunications Borrowers. p. 33.

13. FCC. Trends in Telephone Service. pp. 55, 58.

14. FCC. Trends in Telephone Service. p. 63.

15. FCC. Trends in Telephone Service. p. 55.

16. Association for Local Telephone Service. Hereafter, "ALTS."

17. FCC, Industry Analysis Division. 1998. Local Competition. p.55.

18. Merrill Lynch. 1998. CLEC Vital Signs: Update For 3Q98 Results and Trends. Table 11.

19. Merrill Lynch. 1998. CLEC Update: Continued Weakness in the Sector Creates a Great Buying Opportunity. p. 26.

20. FCC. Trends in Telephone Service. pp. 45, 46, 49.

21. Merrill Lynch. 1998. CLEC Vital Signs: Update For 3Q98 Results and Trends. p. 6.

22. Merrill Lynch. Op. Cit.

23. The Telecommunications Resellers Association. 1998. Report submitted to the House Commerce Committee.

24. ALTS.

25. Merrill Lynch. Op. Cit. p. 7. Data from several companies were not available to be included in that calculation.

26. Federal Communications Commission. 1998. FCC Fiber Deployment Data - End of Year 1997. p. 40.

27. Compustat data.

28. ALTS data.

29. ALTS data.

30. United States Telephone Association. 1998. Local Market Wide Open to Competition.

31. Federal Communications Commission, Industry Analysis Division data.

32. The Telecommunications Resellers Association. 1998. Report submitted to the House Commerce Committee.

33. Federal Communications Commission, Industry Analysis Division data.

34. FCC, Local Competition. p.38. Also, FCC Industry Analysis Division data.

35. Lawyer, Gail. 1998. "Leader of the Pack" in X-Change, October 1998. p.22. More formal data are not yet reported.

36. Cellular Telecommunications Industry Association. 1998. Semi-Annual Data Survey: June 1985 to June 1998. Hereafter, "CTIA Survey results."

37. CTIA Survey results.

38. CTIA Survey results.

39. CTIA Survey results. Also, BLS employment data.

40. CTIA Survey results.

41. Federal Communications Commission. 1998. Third Annual CMRS Competition Report. Appendix B, p. B-4. Hereafter, "FCC CMRS Report."

42. FCC CMRS Report. pp. 19-20.

43. CTIA Survey results.

44. CTIA Survey results, adjusted for inflation using the Consumer Price Index (CPI).

45. CTIA Survey results.

46. U.S. Department of Commerce.

47. See the U.S. Government Working Group on Electronic Commerce, First Annual Report, November 1998, and A Framework for Global Electronic Commerce issued by President Clinton on July 1, 1997.

48. Atkinson, Robert D., and Randolph H. Court. 1998. New Economy Index: Understanding America's Economic Transformation. Washington, D.C.: Progressive Policy Institute, p. 19. Hereafter New Economy Index.

49. New Economy Index. p. 8.

50. Federal Communications Commission. 1998. Fiber Deployment Update.

51. FCC Trends. Table 19.3.

52. New Economy Index. p. 30.

53. New Economy Index. p. 30.

54. The estimates of adult users are from Pew survey results and the adult population of the United States. The Pew Research Center for the People and the Press. Technology Survey 1998 results and report, "Online Newcomers More Middle-Brow, Less Work-Oriented: The Internet Audience Goes Ordinary." Hereafter, "Pew survey results."

55. New Economy Index. p.31.

56. Internet sales data from Boston Consulting Group and shop.org, Online Retailer Survey.