Eli M. Noam is a professor of finance and
economics and director of the Columbia Institute of Tele-Information at Columbia
University Graduate School of Business.
As
telecommunications are moving inexorably towards competition, deregulation, and
fiber optics, the most fundamental questions for telecommunications policy are
rarely asked: After competition, what? After deregulation, what? And
after broadbanding, what?
Most observers focus on the present
bottlenecks—technological, regulatory, and financial. Yet in the United States,
the day is not far off when entry will be wide open; when fiber is widespread
in most stages of most networks (we are now just haggling over the dates); when
radio-based carriers fill in the white spots in the map of telecommunications
ubiquity; when foreign carriers operate in America. In such an environment,
what market structure can we expect? And what regulatory environment need we
erect?
This article will argue that a central
institution of the emerging telecommunications environment will be systems
integrators, which collectively will form an interconnected system of
systems. The impact of such developments on traditional regulation is the
subject of this essay.
The conventional scenario for the
evolution of impact of such developments on traditional regulation is the
subject of this essay.telecommunications, offered by traditional state monopoly
carriers around the world, is the inte-grated single superpipe merging all
communica-tions links into a single conduit controlled by themselves and
interconnected internationally with similar territorially exclusive superpipes.
This scenario of integration took no account of the organizational centrifugal
forces that were exerting themselves, first in the United States and now
increasingly in other countries. Instead of consolidating, the network
environment keeps diversifying.
Take as an example local transmission,
which was widely considered to be a natural monopoly’s natural monopoly. Yet
today, we can identify a wide variety of other potential and credible
participants in rival local transmission: fiber- based metropolitan area
networks; cable television providers; radio-based and cellular carriers; radio
tails of electric utilities; building-based shared-tenant services; and other
local exchange companies crossing franchise lines.
Similar lists can be made for other
segments of the network, whether they are in domestic long-distance,
international, mobile, or switching. These physical network elements become
linked with each other through various interconnection arrangements and form
what I termed a few years ago the "network of networks."
The Role of Systems Integration
Yet this is not the end of the story.
Competition begets diversity; diversity begets complexity; and complexity leads
to efforts at simplification. This balkanized environment, so different from
the technologists’ model of the single superpipe, must be structured for the
telecommunication user’s benefit. There are several ways to integrate the
numerous network pieces into a usable whole.
1. Users’ self-integration. This is basically today’s system for American residential
users where choice is available. They arrange for their own long-distance
company and equipment. Large users, too, often put together networks on their
own, by leasing lines, buying and operating equipment, etc. Self-integration
gets complicated very quickly as the number of carriers, services, prices, and
equipment options multiplies. For most users, even large ones, it is not a
practical option. A related technique is terminal-based integration, with the
user’s terminal equipment incorporating some built-in intelligence that can
make the right choices among carriers on a real-time basis. The PBXs of large
corporate users usually have a so-called "least cost routing" option.
This concept has been extended to the residential market by one of Japan’s long-distance
competitors, DDI, which has persuaded millions of Japanese to buy special
terminals and receive a database that can automatically pick the cheapest
carrier for any given call. But this method, too, still suffers from the
associated transaction costs once it goes beyond basic transmission.
2. Carriers’ integration by expansion. Carriers could enter horizontally into new geographic
markets or vertically into new services—by expansion, merger, or acquisition.
Realistically, it is hard to imagine today any company that is big and varied
enough to offer successfully all types of facilities and
services—telecommunications, computers, enhanced services, and
equipment—locally, domestically, and internationally. This has led to a
variant, namely joint ventures among carriers, where several companies
specializing in different market segments link up with each other through
institutionalized cooperation. This is a likely scenario, and one which is
emerging. We will discuss its problems further below.
3. Integration by systems integrators. Perhaps the most promising scenario for putting together the
various bits and pieces of networks and services is for a new category of
"systems integrators" to emerge that provides the end user
(corporate, governmental, affinity group) with access to a variety of services
in a one-stop fashion. Such specialized integrators, whose predecessors are
known as outsourcers or managed data services providers, might typically
assemble packages of various types of services and equipment, customizing the
packages to the specific requirements of their customers. They could operate a
least-cost-routing system, switching users around from carrier to carrier,
depending on the best deal available for a given time and route. An
international market in transmission capacity is likely to emerge, consisting
of future contracts and a spot market operating in real time.
The characteristic of "pure"
systems integrators—for there will be various hybrids—is that they do not own
or operate the various sub-production activities but merely select optimal
price and performance elements, package them, manage the bundles, and offer
them to the customer on a one-stop basis. Systems integrators are similar to
general contractors in construction projects, travel packagers, or computer
service firms. They relieve customers of the responsibility of integration for
which expertise is required. To these customers, the identity of the underlying
carriers and their technology might be unknown as transmission becomes a
commodity.
Who will be the telecommunications
systems integrators? They are likely to range from today’s resellers and value-
added providers, computer systems providers, defense contractors seeking
diversification, and corporate networks with excess capacity to carriers such
as local exchange companies, long-distance and international telephone firms,
cable television operators, and metropolitan area networks. They are also
likely to compete vigorously with other systems integrators.
Today, systems integrators exist only for
large customers and customer groups, but tomorrow things may be quite
different. The next step is for systems integrators to put together
individualized networks for personal use, or personal networks. This
means individually tailored "virtual" network arrangements that serve
individualized communications needs and provide easy access to frequent
personal and business contacts, data sources, transaction programs, video and
audio publishers, data processing and storage, bulletin boards, and personal
information screening. A systems integrator is also likely to provide to
residential users a tele-mailbox—a customer’s telecommunications node at
or near his premises—into which various communications flows terminate.
As these systems integrator-provided
networks develop, they will access and interconnect into each other and form a
complex interconnected whole sprawling across carriers, service providers, and
national frontiers. The telecommunications environment evolves from the
"network of networks," in which carriers interconnect, to a
"system of systems," in which systems integrators link up with each
other.
The Future of Regulation
This arrangement of customized networks
bundled together and managed by systems integrators will provoke widespread changes
in government regulation of telecommunications.
Regulation had been essential to the old
system, partly to protect against monopoly, partly to protect the monopoly
itself. Those rationales for regulation evaporate as the transition to
competition moves forward. What must now be addressed is the appropriate scope,
if any, for continued regulation of the era of the systems integrators.
Why do we have regulation of
telecommunications? To some it is merely an exercise in capture and
rent-seeking by powerful interest groups. To others, it is based on underlying
public policy goals, including restriction of market power, free flow of
information across the economy and society, and technological innovation. There
is truth in both views, and they are not mutually exclusive. To assure these
objectives, regulators and courts instituted a variety of regulatory policies,
such as universal service with rate subsidies, common carriage, interconnection
rules, quality standards, and limited carrier liability. But in a system of
system integrators, the traditional forms of regulation may be outdated. New
thinking is needed about which forms of regulation will remain, as well as what
new regulatory issues may arise in the new environment.
In telecommunications, government regulation
existed partly to affect the balance of power between huge monopoly suppliers
on the one hand and small and technically ignorant users on the other. The
political and administrative process was used to alter market outcomes. In
return, the dominant carriers received protection from competition. Even where
competition emerged with rival carriers, customers still had no expertise in
dealing with a complex set of services and products. In a system of systems, on
the other hand, the imbalance changes drastically. Now, systems integrators,
competing with each other for customers, act as users’ agents toward carriers.
They can protect users against carriers’ underperformance and power, and get
them the best deal. This would largely resolve traditional problems of price,
quality, market power, security, even privacy. Business communications should
be more effective than ever. Technological innovation is likely to be
accelerated by knowledgeable buyers and marketers of services. Thus, assuming
that users have a choice among systems integrators and that systems integrators
have a choice among non- colluding suppliers of underlying services, the need
for government intervention declines drastically.
On the other hand, not all traditional
policy goals are fully resolved in a system of systems.
1. Universal service/affordable rates. The emerging systems of systems will
exert competitive pressures on costs and therefore on many prices, thus making
telecommunications more affordable to many. On the other hand, it will be
impossible to maintain the traditional redistributive system of generating
subsidies and transferring them internally within the same carrier from one
class of users to another. Several things will disrupt this arrangement. In a
network of competing carriers, an internal redistribution is not sustainable
once other carriers without redistributive burdens target the subsidizing users
as the most desirable customers. Furthermore, residential users may end up
paying a proportionally higher share than large users, because cost shares in
the substantial joint costs end up allocated inverse to demand elasticity—the
Ramsey pricing rule—and large users have more options and hence greater
elasticity. Thus, the trend that at present is described as a
"rebalancing" of prices towards cost would go much further, burdening
inelastic customers disproportionately. Nor can one expect to continue to rely
on a system of access charges to provide the source of subsidies, since those
charges imply access into "the" network, which will be a meaningless
concept where alternative transmission is easily available.
Yet this need not spell the end of
support schemes. If one wants to subsidize some categories of service or users
for various reasons of policy or politics, it is still possible to do so, only
in different ways. For example, one alternative mechanism to finance desired
subsidies might draw on general government revenue, or, more likely, on some
form of communications charges. One possibility might be communications
value-added fees that would be neutral with respect to the extent of
integration, the nature of the carrier, and geographic location. The revenues
might go to a "universal service fund" which would be used to support
certain network providers or categories of users. This charge would replace the
present hidden tax system and would make it visible and accountable.
Systems integrators, by aggregating the
demand of many small customers, can provide them with a higher demand
elasticity with respect to carriers, and thereby generate low prices and low
shares in fixed costs. Systems integrators thus serve, in effect, as
arbitrageurs in demand elasticity. That is likely to increase their
attractiveness to customers over staying as "self-integrating" direct
customers of carriers, and thus to accelerate the move to systems integration.
On the other hand, those customers not able to obtain systems integrator
service, perhaps because they are only reached by a monopoly carrier, would end
up bearing a greater cost share. Also, systems integrators will use
differential pricing, and charge, for example, rural customers a price that
reflects the greater cost in serving them. Should the political system
determine that the rural or poor customers should be supported, revenues for
such a policy would have to be raised in other ways, as discussed above.
Reforming the redistributive system will
be hard enough. Even so, it will be easier than dealing with the more
fundamental problem of financing carriers in a system of systems. The advantage
of systems integrators is that they pay to competing carriers a price based
only on the latter’s marginal costs and can pass that low cost on to their
customers. Yet most costs in a capital-intensive industry such as
telecommunications networks are fixed, and would not get compensated in such an
arrangement. Carriers would not break even. The long-term result would be
either a disinvestment in networks, the reestablishment of monopoly, or oligopolistic
pricing. Because none of those scenarios is desirable or popular, a possible
result would be a reregulation of market structure, pricing, and investment.
Another form of government involvement, based on arguments of public
infrastructure, might be a publicly imposed financing scheme, for example, a
usage-insensitive charge on systems integrators’ and subscribers’ access lines,
dedicated circuits, etc., as a contribution towards carriers’ fixed costs.
2. The free flow of information. In the traditional network environment,
the granting of access and nondiscriminatory content neutrality is required of
the general "public" networks by common carriage regulation and even
common law. But common carriage requirements do not apply to systems
integrators. They can institute restrictions on their systems, and exclude
certain types of information, subjects, speakers, or destinations.
One of the central observations of the
"law and economics" school of thought has been the fundamental
economic efficiency of the common law. The implication is that common carriage,
as the product of common law judges later codified by statutes, was an
economically efficient institution. Among its purposes was reduction of market
power; protection of an essential service; protection of free flow in goods and
information; promotion of basic infrastructure; reduction in transaction costs;
and limited liability.
Yet the institution of common carriage,
historically the foundation of telecommunications, will not survive in a system
of systems. To clarify: "common carriers" (the misnomer used to refer
to telephone companies) will continue to exist, but the status under which they
operate—offering service on a nondiscriminatory basis, neutral as to use and
user—will not.
The blows to traditional common carriage
do not come from rival telecommunications carriers such as MCI, but from two
new directions. The first is the increasing overlap between the common carrier
system and well-developed mass media private contract carriers such as cable
television networks, which in a remarkably short period have wired the nation
with a second and powerful network system, and which are on the verge of
entering point-to-point, switched, and mobile telecommunications services.
Systems integrators represent a second challenge. As mentioned, common carriage
does not apply to systems integrators.
In head-to-head competition between a
common carrier and a private contract carrier or systems integrator, the former
is at an inherent disadvantage:
· A common carrier cannot use differentiated pricing due to its non-discrimination obligation and because it cannot prevent arbitrage. Price-discriminating rivals can offer services to some customers at a low enough price to induce them to sign up, and use their contribution to revenues to underprice a common carrier for low-elasticity customers.
·
A common
carrier must serve a contract carrier or systems integrator, but not vice
versa. There is no reciprocity. Competitors can use valuable parts of a common
carrier’s operations, but need not share their own unique features.
·
A common
carrier cannot pick customers.
·
A common
carrier cannot manage the competition among its customers and benefit from it.
·
In putting
together a service package, the systems integrator can pick and choose among
the lowest-price component providers, while the common carrier is likely to
offer only its own.
·
Competition
for transmission and other services will lower the price charged to systems
integrators to marginal cost, which is likely to be lower than the average cost
for both common and contract carriers of providing such services.
As a result, a systems integrator may
provide services more cheaply, even though it uses the carriers’ underlying
transmission facilities!
It is unlikely that the common carriers
will simply sit by in such a situation. They will operate their own systems
integrators, and they will move to contract carriage themselves, partly based
on the argument of "meeting competition." And that is, indeed, what
is already starting to happen.
This kind of erosion of common carriage
is unavoidable in the long term. The only way to prevent it might be to force
systems integrators to become common carriers, but this would have to be
inevitably extended to most private networks, contract carriers, media, and
enhanced service providers. This seems neither practical nor desirable.
Where alternatives are stark, the
possibility of a mixed system suggests itself. There are several possibilities
for a hybrid system. But none of them is likely to stem the long-term dynamic
of shrinking common carriage, both across carriers and industries, and within
mixed firms. In the long term, common carriage will not survive.
As a result, the system of systems would
have the capacity for a large number of voices, yet it might still result in a
narrower spectrum of information, because systems integrators and carriers
would not want to be identified with certain types of uses and users. Take for
example birth control information offered by an abortion clinic hotline. Faced
with negative publicity and pressure, service providers with discretion in the
choice of customer may drop the service as a business decision. Competition may
not resolve this problem since all carriers will be under similar pressures. It
is of course likely that "alternative" carriers and systems
integrators will emerge to serve such uses. Yet this solves only part of the
problem. The need for the various systems to access each other, and for
information to travel over numerous interconnected carriers, means that the
restrictiveness of any one of the participants would require everyone else to
institute content and usage tests before they can hand over traffic, or they
must agree to the most restrictive principles. Information travels across
numerous subnetworks until it reaches its destination, and nobody can tell one
bit apart from another. If each of the networks and systems integrators sets
its own rules about which information is carried and which is not, information
would not flow easily. Transaction costs would rise. The reason for common
carriage generally, whether in transportation or communications, is to foster
infrastructure and reduce transaction costs. As such, it is similar to other
societal arrangements to encourage economic transactions, by devices such as
legal tender status for currency, negotiable instruments in commercial
transactions, and limited liability for corporations. Thus, even if common
carriage erodes, its neutrality principles will remain important, and may
survive in other regulatory forms.
3. Interconnection and compatibility. As various discrete networks grow, they
must cooperate in terms of technical standards, protocols, and boundaries. Yet
interconnectivity is not normally granted by incumbent firms. That is the lesson
of decades of American experience. Requirements such as open network
architecture, comparably efficient interconnection, or collocation have been
part of the evolution towards competition. In effect, these provisions
regulated in order to deregulate, at least in the transitional phases. Similar
problems are likely to arise in the emerging system of systems. At issue will
be the rules of interconnection for multiple hardware and software subnetworks
and their access into the integrated whole.
New Problems?
There are several possible regulatory
problems associated with systems integrators.
1. Integrator power? If there are strong economies of scale
and scope in systems integration, only a few large firms would survive. In
theory, integrators with market power might sell only a full range of services
to the end user, charge monopolistic prices, force a carrier to enter into
exclusive arrangements, or control access to the "tele- mailbox."
These are fairly standard problems of vertical extension of market power in one
stage of production into other stages. Without such underlying market power no
market distortion would be sustainable. Such problems can be dealt with through
regular antitrust enforcement.
The underlying question, though, is
whether market power in systems integration is likely. Sources of market power
might include the ability of a large systems integrator to get advantageous
rates from carriers or to set aside proportionately less spare and redundant
capacity by averaging out demand spikes across its more numerous customers. On
the other hand, any customized service operation requires close attention to
and contact with customers, and this factor does not favor large-scale firms.
Generally, it is hard to imagine that the nature and shape of economies of
scale are similar for each layer of the hierarchy of communications services,
from basic transmission up to computer-based applications. Thus, integrator
power is unlikely.
2. Carrier power? Traditional carriers have some advantages
in systems integration. They include the coordination of planning, advance
information, established goodwill, and reduced transaction costs for
operations, all under one corporate roof. Carriers functioning as systems
integrators could favor their own services or equipment. Furthermore, they have
the foundation of a major transmission element. However, this base is also a
burden. To be truly competitive as a systems integrator, a traditional
carrier’s systems integration operation must be willing to compete against its
own carrier, use alternative carriers, etc., and in effect become independent.
While this might be conceivable, it might require significant rethinking by
these carriers. Such rethinking has recently begun in the telephone industry.
The Rochester Telephone Co. has proposed to separate itself into a carrier
(R-Net) open to all, and a services operator (R-Com); Ameritech proposed to
separate its carrier from its switching functions, subject to several
conditions.
Looking at the reverse side of a vertical
relationship, a carrier could conceivably provide preferential service to its
own systems integrators. In a competitive environment in a commodity service it
is not economically rational to limit sales to one’s own outlets. And where
market power exists in the carrier’s service segment, regulators are likely to
assure nondiscriminatory service.
Thus, the competitive advantage of the
established reputation of traditional carriers should not be overestimated. One
must resist the temptation to think in narrow telecommunications terms when it
comes to integration. Traditional carriers may have the edge in basic
transmission and switching. But as communications include more and more
"upper level" services, they are more often than not in uncharted
waters. A customer might well prefer a computer firm to a telecommunications
carrier, reasoning that it is easier to migrate down rather than up the
hierarchy of communications. This might be the reason why computer-based firms
are serious players in the systems integration business, for example DEC, IBM,
or Electronic Data Systems. DEC, for example, replaced Sprint as the systems
integrator for Citicorp’s global network. Other systems integrators include
high-technology firms such as General Electric, or defense contractors with a
desire for civilian diversification and experience in large-scale turnkey
projects. For example, Martin Marietta was a bidder for the federal
government’s huge FTS-2000 network.
In conclusion, it does not seem likely
that a carrier would be dominant in systems integration. At any rate, if
extension of market power were to become a real problem, protections could be
instituted.
3. International asymmetry? The system of systems works as long as
it is competitive in each of its stages, or as long as regulation establishes
nondiscrimination. However, in an international setting neither of those
conditions is likely to be met. Most countries lag behind the United States and
Japan in the evolution of networks. The traditional monopoly carrier is almost
always firmly entrenched and operating in all stages of communications.
Consequently, systems integrators cannot truly compete against governmental or
semi-official Public Telecommunications Organizations (PTOs) in systems
integration, except in market niches. This might be considered to be an
internal issue for these countries, except that it has a global anticompetitive
impact. That is because some of these PTOs are aggressively pursuing
international systems integration themselves, while at the same time holding
gate-keeper powers over entry into their own home markets. Thus, the PTO of an
important European country could restrict the effectiveness of an American
systems integrator to offer global services, while at the same time entering
the more liberalized environment in America. It could also operate to benefit
the interests of allied equipment manufacturers.
Of course, other countries's PTOs can
play the same game, and as a result, a new trend of international carrier
collaboration has emerged in which major PTOs enter into joint ventures of
systems integration. Potentially at least, these alliances of dominant national
carriers could create international cartels, and barriers to competitive entry
of other systems integrators, whether in their home countries or
internationally. It has the anticompetitive potential of "whipsawing"
in which a one-sided liberalization across frontiers permits the remaining
monopolist to appropriate fully the previously shared monopoly profits. To
prevent this it is essential to press internationally for nondiscriminatory
access, lease, and interconnection arrangements that are neutral as to the
nature or the nationality of the systems integrator. The United States, being
the largest and most interesting market for systems integrators, can exercise
leadership in pressing for such reciprocity.
Such an effort is likely to be aided by
the openness of the evolving network system, which by not stopping at national
frontiers will erode national regulation. Telecommunications will transcend the
territorial concept, and the notion of each country having full territorial
control over electronic communications will become anachronistic. As
communications are becoming distance-insensitive, system integrators will
reroute and arbitrage traffic in more cost-effective ways, thereby undermining
attempts to set rules administratively for prices and service conditions.
Conclusion
The purpose of this article is not
to analyze the various merits of policy options, but rather to point out that
the introduction of vigorous competition will not be the "end of
history" as far as regulation is concerned. Government is not likely to
disappear from this area. In the 1980s, telecommunications policy was centered
on open entry. That was correct then and now. But in the 1990s
second-generation issues involving the integration of the various
network parts will be at the forefront.
The coming era of systems integration
will demand changes on the part of regulators. Those changes include: 1)
permitting a system of competitive systems integration to emerge and removing
the roadblocks to its operation; 2) moving out of those areas of regulation
which can be handled by the new system of systems itself; 3) restructuring
traditional forms of regulation; and 4) identifying and dealing with potential
problems in the system of systems, such as the free flow of information,
interconnectivity, international reciprocity, and the viability of the
underlying network infrastructure. Dealing with such issues is a unique undertaking
because many of them are new. None of the developments anticipated in this
article are happening overnight, though some are already manifest. But that
should not lead us to ignore them. Opening telecommunications competition will
prove to have been the easy part. Dealing with the consequences will be the
next and more difficult challenge.