FTC Staff Comment Before the Federal Communications Commission Concerning Reclassification of AT&T as a Nondominant Carrier

Before the
FEDERAL COMMUNICATIONS COMMISSION
Washington, D.C. 20554
In the matter of
American Telephone and 	)
Telegraph Company 	)
)
Reclassification of AT&T 	) 	CC Docket No. 79-252
as a Nondominant Carrier 	)
Reply Comment of the Staff of the
Bureau of Economics
of the Federal Trade Commission *
June 30, 1995

*
This comment represents the views of the staff of the Bureau
of 	Economics 	of 	the 	Federal 	Trade 	Commission. 	They 	are 	not
necessarily 	the 	views 	of 	the 	Commission 	or 	any 	individual
Commissioner. 	Inquiries regarding this comment should be directed
to 	Michael 	R. 	Ward 	(202-326-2096) 	of 	the 	FTC’s 	Bureau 	of
Economics.

Before the
FEDERAL COMMUNICATIONS COMMISSION
Washington, D.C. 20554
In the matter of
American Telephone and 	)
Telegraph Company 	)
)
Reclassification of AT&T 	) 	CC Docket No. 79-252
as a Nondominant Carrier 	)
Reply Comment of the Staff of the
Bureau of Economics
of the Federal Trade Commission 1
I. 	Introduction and Summary
The 	staff 	of 	the 	Bureau 	of 	Economics 	of 	the 	Federal 	Trade
Commission 	("FTC") 	appreciates 	this 	opportunity 	to 	submit 	this
reply 	comment 	in 	response 	to 	the 	Federal 	Communications
Commission’s 	("FCC") 	Public 	Notice2 ("Notice") 	concerning 	AT&T’s
Motion 	to 	be 	reclassified 	as 	a 	"nondominant 	carrier."3 AT&T

1 This 	comment 	represents 	the 	views 	of 	the 	staff 	of 	the
Bureau 	of 	Economics 	of 	the 	Federal 	Trade 	Commission. 	They 	are
not 	necessarily 	the 	views 	of 	the 	Commission 	or 	any 	individual
Commissioner. 	Inquiries 	regarding 	this 	comment 	should 	be
directed to Michael R. Ward (202-326-2096) of the FTC’s Bureau of
Economics.
2 Public 	Notice 	on 	comments 	on 	the 	motion 	for
reclassification 	of 	AT&T 	as 	a 	nondominant 	carrier 	in 	CC 	Docket
79-252 (DA 95-920) released April 25, 1995.
3 Motion 	for 	Reclassification 	of 	American 	Telephone 	&
Telegraph 	Company 	as 	a 	Nondominant 	Carrier, 	CC 	Docket 	79-252
(filed Sept. 22, 1993).

2
attached 	to 	its 	recent 	Ex 	Parte 	Presentation
4 an 	FTC 	Bureau 	of
Economics 	Staff 	Report5 ("Staff 	Report") 	that 	attempts 	to 	measure
AT&T’s market power. 	Subsequently, Bell Atlantic, BellSouth, SBC,
and 	Pacific 	Telesis 	attached 	to 	their 	comment 	a 	study 	by 	NERA6
("NERA Study") that purportedly tests and rejects a key assumption
of the 	Staff 	Report, 	using 	data 	generated 	from 	the 	Staff 	Report.
This 	reply 	comment 	suggests 	that 	NERA 	may 	have 	inappropriately
generated its data using estimates from the Staff Report, and that
had 	appropriate 	data 	been 	used, 	the 	results 	of 	the 	NERA 	Study
might have been consistent with those of the Staff Report.

4 Ex 	Parte 	Presentation 	in 	Support 	of 	AT&T’s 	Motion 	for
Reclassification 	as 	a 	Nondominant 	Carrier 	CC 	Docket 	no. 	79-252
(April 20, 1995).
5 Michael 	R. 	Ward, 	Measurements 	of 	Market 	Power 	in 	Long
Distance 	Telecommunications, 	FTC 	Staff 	Report 	(April 	1995). 	The
Report 	was 	filed 	by 	AT&T 	as 	Attachment 	T 	of 	its 	Ex 	Parte
presentation 	in 	support 	of 	AT&T’s 	Motion 	for 	Reclassification 	as
a 	Nondominant 	Carrier. 	An 	earlier 	version 	of 	this 	report 	was
submitted 	by 	the 	FTC 	staff 	to 	the 	FCC 	in 	this 	proceeding
(Submission 	of 	the 	Staff 	of 	the 	Bureau 	of 	Economics 	of 	the
Federal 	Trade 	Commission 	regarding 	Reclassification 	of 	AT&T 	as 	a
Nondominant Carrier (CC Docket 79-252) (November 23, 1993)).
6 William 	E. 	Taylor 	and 	J. 	Douglas 	Zona, 	"An 	Analysis 	of 	the
State 	of 	Competition 	in 	Long-Distance 	Telephone 	Markets," 	(May
1995).

3
II. 	Expertise of the Staff of the Federal Trade Commission
The 	FTC 	is 	an 	independent 	administrative 	agency 	charged 	with
maintaining 	competition 	and 	safeguarding 	the 	interests 	of
consumers.7 The 	staff 	of 	the 	FTC, 	upon 	request, 	often 	analyzes
the 	competitive 	or 	economic 	efficiency 	implications 	of 	regulatory
or legislative proposals. 	In the course of 	this 	work, 	as 	well 	as
in 	antitrust 	and 	consumer 	protection 	research 	and 	litigation, 	the
staff applies established principles and recent developments, both
empirical 	and 	theoretical, 	to 	competition 	and 	consumer 	protection
issues. 	For example, the staff submitted a 	comment 	to 	the 	FCC 	on
its 	proposals 	to 	modify 	the 	regulations 	concerning 	the 	local
transport 	of 	interstate 	long 	distance 	traffic
8 and 	the 	economic
efficiency 	aspects 	of 	regulating 	AT&T’s 	commercial 	services 	and
optional calling plans.9
The 	staff 	of 	the 	Bureau 	of 	Economics 	of 	the 	FTC 	also 	has
studied 	various 	economic 	aspects 	of 	the 	telecommunications
industry. 	These 	studies 	include 	the 	effects 	of 	price 	and 	entry

7 15 	U.S.C. 	'' 	41 	et 	seq. 	The 	FTC 	Act 	declares 	unlawful
unfair 	methods 	of 	competition 	and 	unfair 	or 	deceptive 	acts 	or
practices.
8 Comment 	of 	the 	Staff 	of 	the 	Bureau 	of 	Economics 	of 	the
Federal 	Trade 	Commission 	regarding 	Expanded 	Interconnection 	with
Local 	Telephone 	Company 	Facilities 	(CC 	Docket 	No. 	91-141 	Phase 	I
and CC Docket No. 80-286) (March 5, 1993).
9 Reply 	Comments 	of 	the 	Staff 	of 	the 	Bureau 	of 	Economics 	of
the 	Federal 	Trade 	Commission 	regarding 	Revisions 	to 	Price 	Cap
Rules for AT&T (CC Docket No.93-197) (October 23, 1993).

4
regulations 	on 	long 	distance 	telephone 	service,
10 and 	estimates 	of
market power in the long distance industry (Staff Report).
III. NERA’s 	Pricing 	Behavior 	Test 	Overstates 	the 	Likelihood 	of
Collusion
The 	Staff 	Report 	empirically 	assessed 	the 	competitiveness 	of
the 	U.S. 	long 	distance 	telephone 	market 	by 	estimating 	firm-
specific 	long-run 	residual 	demand 	elasticities 	for 	AT&T 	and 	its
rivals. 	Measurement 	of 	a 	firm’s 	residual 	demand 	elasticity
provides 	an 	estimate 	of 	its 	market 	power.11 To 	calculate 	residual
demand 	elasticities, 	the 	Staff 	Report 	estimated 	the 	degree 	of
product 	substitutability 	by 	consumers 	(i.e., 	Marshallian 	demand
elasticities) 	and 	assumed 	that 	AT&T’s 	rivals 	would 	increase 	their
output in response to an attempted AT&T price increase rather than
increase their prices.
12
The 	NERA 	Study’s 	test 	of 	the 	validity 	of 	this 	assumption
employs 	a 	time 	series 	of 	AT&T’s 	elasticities, 	constructing 	these
elasticities 	from 	estimates 	in 	the 	Staff 	Report.
13 The 	Staff

10 See 	Alan 	D. 	Mathios 	and 	Robert 	P. 	Rogers, 	The 	Impact 	of
State 	Price 	and 	Entry 	Regulation 	on 	Intra-State 	Long 	Distance
Telephone 	Rates, 	FTC 	Bureau 	of 	Economics 	Staff 	Report 	(November
1988).
11 Landes, 	William 	M. 	and 	Richard 	A. 	Posner, 	"Market 	Power 	in
Antitrust Cases," Harvard Law Review 94 (1984) 937-983.
12 For 	an 	explanation 	of 	this 	assumption, 	see 	Staff 	Report,
pp. 19-22.
13 NERA, 	III.B. 	Pricing 	Behavior, 	pp. 	27-32. 	This 	comment
pertains to the implementation of the NERA Study’s test and makes

5
Report 	calculates 	AT&T’s 	firm-specific 	demand 	elasticity 	for 	the
period 	1988-1991 	using 	the 	equation 	0
11 	= 	w1(1-0
LD
),	
+ 	0
1, 	where 	a
firm’s elasticity, 0
11, is determined by the values of the industry
elasticity,0
LD
, 	a 	conditional 	firm-specific 	elasticity, 	0
1, 	and 	an
income 	elasticity, 	,.14 The 	estimates 	of 	these 	parameters 	in 	the
Staff 	Report 	represent 	averages 	over 	the 	1988-1991 	time 	period.
NERA constructs a time-series of elasticities by substituting into
this 	equation 	a 	time 	series 	of 	AT&T’s 	market 	shares,
	w1, 	covering
the period that AT&T was regulated under price-caps (i.e., 1989 to
present). 	In 	creating 	the 	elasticity 	series, 	NERA 	also 	uses
unchanging 	estimates 	of 	the 	industry 	level 	demand 	elasticity, 	0
LD
,
the 	firm-specific 	conditional 	elasticities, 	0
1, 	and 	the 	income
elasticity, 	,, 	generated 	in 	an 	earlier 	version 	of 	the 	Staff
Report.15
In 	assuming 	an 	unchanging 	estimate 	of, 	0
1, 	NERA 	implicitly
assumes 	no 	change 	in 	the 	substitutability 	between 	firms 	(such 	as
AT&T, 	MCI 	and 	Sprint), 	when 	substitutability 	likely 	continued 	to
increase.16 If 	the 	substitutability 	continued 	to 	increase,
CONTINUED
no claims as to the validity of the test itself.
14 This is equation (3) in the Staff Report, p. 14.
15 NERA 	used 	short-run 	parameter 	estimates 	from 	an 	earlier
version of the Staff Report that was submitted to the FCC in this
proceeding in November, 1993.
16 In 	equation 	(3) 	of 	the 	Staff 	Report, 	the 	substitutability
between 	firms 	is 	measured 	by 	the 	firm-level 	conditional

6
estimates 	of 	the 	firm-level 	conditional 	demand 	elasticities, 	0
1,
at 	different 	points 	in 	time 	would 	be 	required 	to 	appropriately
construct 	a 	sample 	of 	elasticities. 	However, 	NERA 	uses 	the 	same
value of 0
1 for every elasticity constructed.
The 	impact 	of 	NERA’s 	assumption 	about 	constant
substitutability 	on 	estimated 	firm 	demand 	elasticities 	is
suggested 	by 	Table 	I, 	which 	presents 	NERA’s 	estimated 	AT&T
elasticity 	values, 	0
11. 	The 	elasticity 	values 	are 	generated 	from
equation 	(3), 	by 	assuming 	constant 	values 	for 	0
LD
, 	0
1 	and 	,, 	and
values 	of
	w1 	for 	the 	1989-1994 	time 	period. 	By 	the 	1988-1991
period, 	AT&T’s 	rivals 	had 	made 	greater 	use 	of 	"1+" 	dialing,
resolved 	early 	billing 	problems, 	and 	extended 	service 	throughout
the 	U.S. 	These 	improvements 	made 	AT&T’s 	rivals’ 	services 	better
substitutes 	for 	AT&T’s 	service 	causing 	AT&T’s 	Marshallian
elasticity to fall an average of 0.45 per year from 1970 to 1990.
17
It 	is 	possible 	that 	the 	rate 	of 	change 	in 	the 	substitutability
between 	firms 	has 	fallen 	since 	then. 	However, 	AT&T’s 	demand 	has
likely 	become 	at 	least 	slightly 	more 	elastic 	since 	1989, 	as
CONTINUED
elasticity, 	0
1, 	while 	the 	term 	involving 	market 	share 	measures
industry demand stimulation effects, not firm substitutability.
17 Before 	AT&T 	faced 	competitive 	pressure 	(MCI 	first 	offered
service 	in 	1970), 	its 	elasticity 	was 	the 	long 	distance 	industry
elasticity 	of 	about 	-0.7 	(see 	e.g., 	Taylor, 	Lester 	D.,
Telecommunications Demand in Theory and Practice (Kluwer, Boston,
MA: 	1994)). 	The 	Staff 	Report 	estimates 	that 	AT&T’s 	average
elasticity 	over 	the 	1988-1991 	period 	was 	-10.1. 	The 	average
annual 	change 	over 	this 	period 	is 	calculated 	as 	[(-10.1) 	-
(-0.7)] / [1991 - 1970] or approximately -0.45.

7
optional 	calling 	plans 	(e.g., 	Friends 	and 	Family) 	have 	become
common, 	increased 	information 	about 	carrier 	options 	has 	reduced
switching 	costs, 	and 	the 	rate 	at 	which 	customers 	switch 	carriers
has 	doubled.
18 Nevertheless, 	even 	a 	tenfold 	reduction 	in 	the 	rate
of change 	in 	AT&T’s 	elasticity 	(to 	0.045 	per 	year) 	would 	still 	be
larger 	than 	the 	range 	of 	elasticity 	values 	(maximum 	value 	minus
minimum 	value) 	predicted 	by 	the 	NERA 	Study 	in 	Table 	I 	(at 	most
0.035 	over 	five 	years). 	In 	this 	case, 	the 	NERA 	Study 	still
understates 	the 	range 	of 	elasticities 	by 	more 	than 	a 	factor 	of
six.19

18 AT&T, 	MCI, 	and 	Sprint 	have 	introduced 	over 	100 	new 	calling
plans since 1989. 	Increased consumer information is indicated by
a 	doubling 	of 	both 	industry 	advertising 	and 	the 	number 	of
telemarketers 	employed 	since 	1992. 	The 	number 	of 	residential
customers 	who 	switched 	long 	distance 	carriers 	increased 	from 	12
million 	in 	1991 	to 	27 	million 	in 	1994 	(Ex 	Parte 	Petition,
Attachment O).
19 With 	a 	tenfold 	reduction 	in 	the 	rate 	of 	change 	in 	firm
substitutability, 	the 	annual 	rate 	of 	would 	become 	0.045. 	The
range 	of 	elasticities 	over 	five 	years 	(1989 	to 	1994) 	would 	be
0.225 	which 	is 	almost 	six 	and 	a 	half 	times 	the 	range 	of 	0.035 	in
Table I.

8
Table I
NERA’s Estimated AT&T Elasticity Values from Equation (3)
Assuming Constant 0
LD
, 0
1 and ,
Year
AT&T
Market
Share
w1
Staff Report
0
LD = 	-0.70
0
1 = -10.78
, = 1.0
Nov. 1993 Version
0
LD = -0.65
0
1 = -3.15
, = 1.0
1989 	69.3% 	-10.572 	-2.907
1990 	66.4% 	-10.581 	-2.918
1991 	64.3% 	-10.587 	-2.925
1992 	62.6% 	-10.592 	-2.931
1993 	60.2% 	-10.599 	-2.939
1994 	59.3% 	-10.602 	-2.942
Range 	0.030 	0.035
If 	NERA 	has 	constructed 	an 	inappropriately 	narrow 	range 	of
elasticity 	values, 	its 	test 	would 	tend 	to 	be 	biased 	in 	favor 	of
finding collusion. 	NERA tests for the presence of collusion among
AT&T 	and 	its 	rivals 	by 	computing 	a 	test 	statistic, 	2. 	This 	is 	a
producer pricing parameter with larger values associated with more
collusive 	behavior 	(NERA 	study, 	pp. 	28-32). 	Since 	2 	is 	estimated
in 	a 	regression 	as 	the 	coefficient 	of 	the 	inverse 	of 	AT&T’s
elasticity 	(1/0
11), 	its 	estimated 	value 	tends 	to 	decrease 	as 	the
range of elasticity values increases. 	To illustrate, suppose that
the 	measured 	values 	of 	0
11 	used 	by 	the 	econometrician 	varied 	from
-2.907 in 1989 to -2.942 in 1994, (a range of 0.035, see Table I),
but 	that 	the 	true 	value 	of 	0
11 	varied 	from 	-2.907 	to 	-3.162, 	(a
range of 0.225, see footnote 19). 	Even with the rate of change in

9
0
11 	falling 	by 	a 	factor 	of 	ten 	(to 	0.045), 	the 	value 	of 	2 	would
likely 	fall 	to 	approximately 	one-sixth 	its 	estimated 	value 	or
about 0.4 rather than 2.55.20

20 In 	a 	simple 	linear 	regression 	of
	Yi 	on
	Xi, 	the 	coefficient
of
	Xi 	($) 	is 	equal 	to 	the 	ratio 	of 	the 	covariance 	of
	X i 	and
	Yi
divided 	by 	the 	variance 	of
	Xi 	(i.e., 	$ 	= 	cov(
Xi,Y i)/var(
Xi)). 	If
the 	range 	of
	Xi 	were 	to 	increase 	sixfold 	(e.g., 	by 	multiplying
each 	observation 	of
	Xi 	by 	6), 	then 	cov(
Xi,Yi) 	would 	increase
sixfold 	and 	var(
Xi ) 	would 	increase 	thirty-sixfold 	(36 	= 	6 2
). 	The
resulting value of $ would fall by a factor of six.
While 	the 	variation 	in 	AT&T’s 	actual 	elasticities 	is 	likely
larger than that constructed in the NERA study, the actual values
are 	likely 	not 	scalar 	multiples 	of 	the 	NERA 	study’s 	constructed
values. 	In 	this 	case, 	the 	covariance 	of
	X i 	and
	Yi 	may 	not
increase 	exactly 	sixfold 	as 	the 	variance 	of
	Xi 	increases 	by 	a
factor 	of 	thirty-six. 	However, 	without 	other 	information, 	one
would expect a sixfold increase would be the best estimate of its
increase. 	Thus, 	one 	would 	expect 	$ 	to 	fall 	by 	a 	factor 	of 	six,
although it could fall by more or less than this.
The 	simple 	linear 	regression 	logic 	holds 	for 	NERA’s
estimated 	equation, 	even 	though 	NERA 	uses 	a 	more 	complicated
estimation 	procedure. 	NERA 	employs 	a 	multivariate, 	nonlinear,
instrumental 	variable 	estimation 	technique. 	But 	a 	nonlinear
relationship 	can 	be 	approximated 	by 	a 	linear 	Taylor 	series; 	the
multiple-variable 	regression 	simply 	requires 	that 	other 	factors
be 	held 	constant; 	and 	instrumental 	variables 	techniques 	are
likely 	not 	to 	affect 	the 	estimated 	parameter 	since 	there 	is 	no
reason 	to 	believe 	that 	first-stage 	correlations 	are 	changed.
Hence, 	the 	above 	logic 	applies, 	in 	approximation, 	even 	when 	more
complicated estimation procedures are used.

10
IV. 	Conclusion
The 	NERA 	Study 	purportedly 	tests 	and 	rejects 	the 	validity 	of
a 	key 	assumption 	of 	the 	Staff 	Report. 	To 	conduct 	this 	test 	the
NERA 	study 	uses 	estimates 	from 	the 	Staff 	Report 	to 	construct 	a
time 	series 	of 	AT&T’s 	demand 	elasticity 	assuming 	that 	the
substitutability 	between 	firms 	has 	been 	constant 	since 	1989.
However, 	if 	the 	substitutability 	had 	continued 	to 	increase 	the
actual 	range 	of 	elasticities 	would 	likely 	be 	greater 	than 	the
range of the constructed elasticities. 	This implies that the NERA
Study’s 	pricing 	behavior 	estimate 	may 	overstate 	the 	true 	value.
The 	correct 	pricing 	behavior 	estimate 	might 	confirm, 	rather 	than
reject, the Staff Report’s pricing behavior assumption.