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2. Universal affordable service

2. Universal affordable service

Progress toward the goal of universal service

Figure 2.1 presents data from the beginning of the twentieth century to the present on the percentage of households with telephone service and the cost of service relative to the national per capita income. While the cost of service, expressed as a percentage of income, is only one factor affecting the decision to have telephone service, it is certainly the most important factor because it incorporates the two most important economic factors affecting the demand for any commodity--the fluctuation of incomes and prices and their effect on the demand for a product.16

At the turn of the century telephone service had been adopted by a small part of the population, about 5 percent.17 The monthly cost of service was quite high relative to income, about 18 percent. In the first three decades of the century, the relative cost of the service declined dramatically, to around 6.3 percent of income. The penetration rate increased sharply, to just more than 40 percent.

Telephone penetration rates stagnated throughout the Depression, and then skyrocketed in the post-war years. From 37 percent in 1940, penetration jumped to 93 percent in 1980. This rapid spread of telephone service coincided with a dramatic decline in the cost of service relative to income. By 1980 the monthly cost of service had fallen to less than 1 percent of income.

Figure 2.2 shows that the dramatic decline in the cost of telephone service relative to income in the early years was mainly the result of falling real prices.18 Between 1900 and 1930 the real cost of service--the cost of service less inflation, service fees, and so on--fell about 50 percent. Income grew 20 percent. Real income grew more than 300 percent between 1940 and 1980, while the real cost of service fell again about 25 percent. After World War II the declining relative cost of service was mainly a result of rising income levels.19

Universal affordable rates for all

For the six decades between the passage of the Communications Act of 1934 and the Telecommunications Act of 1996, universal service was implemented by setting rates for basic service and applying principles of cost allocation and cost recovery to keep the cost of basic service low and affordable. The cornerstone of this process had been laid down in two fundamental principles of ratemaking, established in case law around the time of the passage of the 1934 Act.20

First, in a series of cases starting in the 1920s, the concept of rate of return regulation (rate of return being the variable rate at which different companies earn profits on their investments) came to rest on the principle of just and reasonable rates, defined by the courts as requirements that regulators grant companies only the opportunity to earn a return commensurate with the risks that they faced.21 This kept the total revenue requirement to be collected from ratepayers under control.

Second, the courts upheld the principle that the costs for shared facilities in the telecommunications network--facilities used for more than one service--should be shared by the full range of services and customer classes that used the network.22 In particular, long distance services were required to cover a part of the cost of the loop facilities that were used in the completion of long distance calls. This kept the share of revenue to be collected from residential rate payers' basic service under control.

From this legal foundation many regulators kept the share of these costs placed on basic service low--the mark-up of basic service prices above direct costs was small--but not below cost.23 Consequently, the share of these costs paid by non-basic services--long distance use, enhanced services such as call forwarding--was high. Overlaid on this cost allocation approach were substantial economic efficiency gains in the industry--fueled by economies of scale that lowered costs as more and more users joined the network--that enabled prices to fall across the board.24

For a long time regulators have engaged in the practice of keeping basic service rates low by allocating joint and common costs to other services. Various industry, academic, and consumer groups have argued about whether keeping rates low involves a subsidy and which way the subsidy flows--to the company or to the consumer and from one class of customer to another.25 Those who intensively use non-basic services (generally business customers) would like to see a larger share of joint and common costs allocated to basic service. This would result in lower rates for the services they rely on more heavily.26 Telephone companies have also argued that a larger share of network costs should be paid by residential ratepayers, who rely more on basic services than other services. If the recovery of these costs were shifted onto basic service, they would have a more secure revenue stream.27

Those who predominantly rely on basic service have argued that their needs do not cause the high costs imposed on the network by the more demanding services and they do not benefit from the higher levels of functionality that have been built into the network.28 They argue that in the 1920s and 1930s these costs were driven by the need for higher quality--a need created by long distance service. From this point of view, the needs of high speed data transmission drove costs in the 1980s; in the years ahead broadband applications will drive costs.29 Those who do not use these services do not feel they should pay for them.

The 1996 Act is not likely to end the debate. Not only does the Act reiterate the belief that universal service depends on a fundamental commitment to affordable pricing based on just and reasonable rates for all households, but Section 254(k) reaffirms the principle of protecting universal service when allocating joint and common costs. Section 254(k) states:

Subsidy of competitive services prohibited. A telecommunications carrier may not use services that are not competitive to subsidize services that are subject to competition. The Commission, with respect to interstate services, and the states, with respect to intrastate services, shall establish any necessary cost allocation rules, accounting safeguards, and guidelines to ensure that services included in the definition of universal service bear no more than a reasonable share of the joint and common costs of facilities used to provide those services. The Conference Report makes a point of stating that in adopting Section 254(k) the House is receding to the Senate.30 The Senate report made it clear that a reasonable share of joint and common costs was the maximum that should be included in the rates for universal service, but that less could be allocated to these services. The Commission and the states are required to establish any necessary cost allocation rules, accounting safeguards, and other guidelines to ensure that universal service bears no more than a reasonable share (and may bear less than a reasonable share) of the joint and common costs of facilities used to provide both competitive and noncompetitive services.31

Above all, consumer advocates view the loop (the wires that connect the end-user to the network and are used to complete all telephone calls--local, intraLATA (local access transport areas) long-distance calls, and interLATA long distance32--and to provide enhanced services) as a shared facility. If the loop were not provided by the existing local exchange companies, telecommunications service providers would have to build their own loops, or rent the use of some other loop in order to sell their services to the public. Because the loop is a joint and common cost shared by competitive and non-competitive services, it is subject to Section 254(k), meaning that universal service services should not bear more than a reasonable share of the loop's joint and common costs.33

It is not only consumer advocates who take this view of the loop.34 Even some local companies point out charges for the use of the loop represent the recovery of joint and common costs.35 State regulators also take this view.36

Consumer advocates see the sharing of joint and common costs as the linchpin of the legislation.37 Affordability can only be ensured when there is a direct link between the growth of information, data, and video services and declining costs for basic access. As the network is filled with enhanced and discretionary services, the cost of network access and plain old telephone service will decline for all people, if the link between network use and basic service rates is well crafted. In a sense, economies of scope--the sharing of facilities between different services--can play the role that economies of scale played in the industry's early days.38

Sources for figures 2.1 and 2.2

U.S. Department of Commerce, Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970 (Washington, D.C., 1975), Tables F1730, R112.

John Robert Meyer, The Economics of Competition in the Telephone Industry (Oelgeschlager, Gunn & Hain, Cambridge, Mass, 1980).

McMaster, Susan E. and James Lande, Reference Book: Rates, Price Indexes, and Household Expenditures for Telephone Service (Industry Analysis Division, Common Carrier Bureau, Federal Communications Commission, November 1995), Table 2.

Federal State Staff, Federal State Joint Board, Monitoring Report, CC Docket No. 87-339, May 1995, Table 1.1.

Council of Economic Advisors, Economic Report of the President, February 1996, Table B-27.

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