TELEMATICS and

INFORMATICS

Vol 2, No 3, pp 223-233, 1985 Copyright ,£~ 1985 Pergamon Press Ltd Printed in USA 0736-5853185 $3 00 + 00

EFFECTS OF DEREGULATION ON COMPETITIVE MARKET OPPORTUNITIES

Elizabeth Johnson

Abstract -On January 1, 1984, AT&T was divested of its 22 operating com- panies. On this same date the Federal Communications Commission (FCC) de- regulated customer premise eqmpment (CPE) thereby restricting the telephone company's (telco) monopoly. This sumulated competmon in the telecommumca- uons marketplace whde also mdivtdualizing the logistical channel of distribu- tion and the communication channel. In the past demand within the logistical channel was dependent upon demand w~thin the communication channel The surge of competiuon igmted by the regulatory changes significantly altered these relauons Competmon from supplier interconnects as well as long d~stance car- r~ers are causing shifts that are changing the industry structure. Th~s paper ex- plores the interdependency of the logistical and communicauon channels within the environment of deregulation.

The most significant landmark in the chronicles of telecommumcations may be the day that AT&T was divested of its 22 operating companies. The event brought to an end the world's largest vertically integrated channel of distribution. On the same day, January 1, 1984, the Federal Communicat ions Commission (FCC) deregulated cus- tomer premise equipment (CPE). CPE is equipment located on the customer's premises and includes both residential and business telephones, private branch exchanges (PBXs) - e x c h a n g e machines that allow switching on the customer's premises, modems and data equipment and teletypewriters.

When the FCC deregulated CPE, the telephone companies ' (telcos) channel structure was restricted to the "telco network" which is still a monopoly that is protected by regulatory barriers. Prior to January 1, 1984 the telephone monopoly extended onto customer premises. With telcos barred from the ownership of CPE, vendors who supply equipment for end users' use in assessing the network became more competit ive with AT&T and independent telcos.

Deregulation and divestiture can be compared to the distribution and network chan- nels within the telecommunications industry. The physical or logistical channel of dis- tribution is a series of firms referred to as middle market wholesalers or broker /agent resellers as demonstrated in Figure 1. These firms facilitate the t ransportat ion flow of equipment from the manufacturer to the consumer. The AT&T "Consent Decrees," which led to the January 1st divestiture, bars the Bell Operating Companies (BOCs) from manufacturing equipment. By divesting the BOCs from the AT&T manufacturing a r m - Western E lec t r i c - the vertically integrated distribution channel was broken into several au tonomous interconnecting units.

As a result of divestiture, vendors crowded into the marketplace. They intensified their

Dr. Ehzabelh Johnson is a professor at Cahforma Slate Un,verslly, Dommquez Hdls.

223

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224

Effects of deregulation 225

distribution systems in order to make equipment available to the BOCs, and ultimately to the massive end-user markets. Prior to this the AT&T integrated channel had been a formidable barrier to interconnect suppliers. With the disconnection of AT&T, Western Electric's market share must become increasingly dependent on the competitiveness of its product features as a valued use within the network channel. The network channel is the transmission network which carries voice and, more recently, bytes and bits of data. The physical products disbursed through the distribution system for the most part sup- port the voice and data network. The demand within the physical distribution channels is dependent upon the demand within the voice and data channels.

The network process begins with a sender of a message, f rom either a residence or a business, to a receiver of that message, who may also be in either a residence or a business. Due to sheer volume of messages transmitted the present network channels in- volve an exchange center as depicted in Figure 2. This is different from the direct message channel between sender and receiver. The exchange center is activated by releasing a receiver for a dial tone. The center locates a channel based on identifying numbers. These numbers are not limited to identification of a channel at the sender's exchange. The numbers can also identify other exchange centers and the receivers attached to them. Numerical exchange switching, once handled by hand cord operation, then by mechanical devices, can now be managed by computers. This computing ability initiated data chan-

LOCAL CENTRAL [ OFFICE EXCHANGE SWITCH

LOCAL CENTRAL OFFICE EXCHANGE SWITCH

Figure 2 Local Network Channel

i " 0

226 Ehzabeth Johnson

nels in the once all voice networks. In the future the computing dimension will probably lead to a reversal in channel demand dependency.

A reversal in channel demand dependency is probable if the interconnect market is going to be a formidable competitor to the telcos and their traditional suppliers. Deregula- tion has triggered a surge of products that for the most part provide benefits similar to those already provided by the established industry. Price and brand strategies dominate a commodity market such as this one, and thereby dominate the consumer buying motives. Interconnects will, of course, find it difficult to compete on a price basis while trying also to recapture their start-up production and market entrance costs. Massive promotional campaigns that increase brand awareness are also impracticable. Product differentiation strategies, however, might lead to footholds in the marketplace.

A competitive edge may be achieved by distinct products with novel product features. Many contemporary innovative features, once only available from telco central office switching centers, are now accommodated by electronic CPE on the customer's premises. The in-place telco wire developed for voice channels is becoming obsolete for use in data channels due to speed and space (bandwith) limitations as electronic technology advances. Interfaces dependent on both computer hardware and software protocol conversion that supports new technological features are imminent. Transmission facilities must become the secondary service to support the demands of the primary product features of emerging data networks. This paper, thus, explores the interdependency of the physical and com- munication channels within the environment of deregulation, and addresses past policies and strategies.

REGULATORY POLICIES AND COMPETITIVE STRATEGIES THAT CHANGED CHANNELS

Until January 1, 1984, AT&T had been barred from the development of information networks. More than any other issue, their inability to access this marketplace provided the impetus for the divestiture. The events leading to both deregulation and divestiture actually began in 1956. In 1956 the Department of Justice (DO J) and the Bell System entered a Consent Decree which left the Bell physical distribution channel structure in- tact, but restricted the company to offering regulated common carrier services. This decree limited effectively AT&T's services and prevented the company from entering the present market driver of unregulated computer services. The reorganization of AT&T on January l, 1984 released the company from the limitation imposed on its business by the 1956 Consent Decree. The company was released from former limitations to ex- plore new network channels with one exception. There is a condition in the modified decree that bars AT&T from engaging in electronic publishing over its own transmis- sion facilities for at least 7 years. That is, 7 years from the date of the final decree. Ex- ceptions do provide for limited electronic directory services and certain currently offered audio information services (time, weather, etc.).

Many other telecommunication channel changes began in 1956. Among the changes was the Hush-A-Phone decision. The Hush-A-Phone decision opened the way for the connection of customer provided attachments to telephone equipment. It was the first in a series of FCC decisions that restricted the telco's channel. Table 1 provides the chronological view of major decisions that caused channel changes.

Although the Hush-A-Phone was the first device to be used in minimally altering the telco channel by allowing an attachment to the telephone itself, the competitive market impetus resulted from the 1968 Carterphone decision. The Carterphone device actually allowed mobile radio transmission through the public telephone network. This channel

Effects of deregulat ion

Table 1. Deregulation Events Influencing Channel Changes.

227

DATE DEREGULATION EVENT IMPACT FOR CHANNEL CHANGES

1956 Consent Decree Left Bell's vertically integrated channel (Between DOJ & Bell) structure intact & restricted the company of-

fermg to regulated common carrier services.

Opened competition, amending the monop- ohstic vertically integrated channel.

1956 Hush-A-Phone (Allowed customers to attach a device to a telephone although prohibited attachment to the network )

1959 Above 890 MH3 (Perm=tted prtvate ownersh=p of m=crowave networks )

1968 Carterphone (Perm=tted customer-owned equipment to be connected to the phone network.)

1969 MCI (Authortzed Microwave Communications, Inc, between Chicago & St Louis.)

1971 Specialized Common Carriers (SCCs) (Authorized SCCs but limited them to pro- vide private line services.)

1971 Computer Inquiry I (Allowed unregulated computer service through separate subsidiaries, although AT&T remained barred )

1972 Open Skies II (Created domestic satellite commumcations carriers.)

1977 Execu net (Allowed SCCs to offer ordinary long- distance telephone servtce to the public in competition with AT&T.)

1981 Computer Inquiry II (Separated basic common carner services from customer premise equipment and enhanced service.)

1981 DEMS (Approved Digital Electronic Message Servlce--a dig=tal telecommunication net in 10GHz band, based on 1978 Xerox XTEN plan )

1981 Record Carrier Competition Act (Allowed Western Union Telegraph back into inter- national serv=ce and IRCs to extend serv- ices domest=cally )

1982 International Voice/Data (AT&T allowed to provide overseas data services; IRCs could offer voice services on a primary basis.)

1982 Dismissal of US V AT&T and modification of the 1956 Consent Decree

1983 Modified Final Judgment (BOC filed FCC consolidated application under Sec. 214 & 310(d)--Commumcation Act to transfer interstate hnes & radio licenses" FCC adopted rules for access charges.)

Beginnings of competitive network channels.

Initiated competition in the physical channel particularly for the business customer

The first duplicate network channel com- petltwe with the public network

Separate new channels competitive with the Bell long line channels that fall under the name of OCCs.

Beginning of VAN channels.

Estabhshed satellite channels competitive with the existing wire channels.

Opened the door for price competition in long distance channels

Limited TELCO network channel to trans- missions not to consumer premises

Expanded network channels to digital transmission.

Permitted competitive domestic channels for records

Data channels can now provide channels for voice.

Physical channel structure to be reorganized, AT&T barred for 7 years from new channels of electronic publishing Reorganization of long distance & exchange channels

228 Ehzabeth Johnson

attachment could have developed years before, but the Bell System used an anti-com- petitive strategy that succeeded in preventing the Carterphone from entering the market. Bell claimed that any foreign device attached to the network would adversely affect the system. With a favorable FCC ruling for Carterphone, telephone equipment vendors- who could be manufacturers, distributors, agents, or independent brokers-sprang up to offer alternatives to the telco's offerings. These vendors initiated competition in the vertically integrated system.

Also in the year 1956, the FCC ordered an investigative review of microwave and other frequencies above 890 MH3. Three years later in 1959 the Commission found, as a result of the 1956 investigation, that adequate frequencies were available for private point-to- point communications systems and that private installations should be allowed. Prior to this, specific microwave frequencies were available principally for assignment to public safety agencies, power utilities and pipehnes (right-of-way companies), and the broad- casters of remote television pick-up and studio-transmitter links.

By allowing private installations, alternative channels could become competitive with the monopolistic telco channels. AT&T recognized this possibility and in a competitive pricing strategy introduced WATS switched services at the end of 1960. In the following year AT&T also implemented Telpack which is a leased private line service dedicated to the user. Private line facilities offered point-to-point communication lines or multipoint communication, and provided most of the service advantages of private microwave systems.

These services were targeted to groups like government and business organizations most likely to by-pass the system. The services were effective. They spared target groups the construction and maintenance costs associated with the design of a private microwave system. Both the Telpak and WATS price discrimination strategy was successful in the prevention of network by-pass until 1971 when MCI and the other Specialized Common Carriers (SCCs) received final FCC approval. Although the SCCs, which came to be known as Other Common Carriers (OCCs), could construct and operate competitive microwave systems, they were initially restricted to private lease line service. Their com- petitive entrance into switched services came only after MCI began to market its Execunet service in 1975. The basis of the pricing strategy caused the delay.

Telpak and WATS produced an effective price discriminatory strategy. Their customers or users, were unable to buy the services and then resell single line services to sub-leasors at prices that were lower than the price of single line service offered by AT&T. Although m many instances MCI used its own microwave network, the predatory disadvantage of discriminatory pricing would be at work because services would be available at lower prices. From the customer's point of view, the Execunet service was the same service as ordinary switched long-distance service but with more competitive rates.

AT&T compromised by offering a new tariff known as ENFIA (Exchange Network Facilities for Interstate Access). While this significantly increased rates for exchange lines, it allowed other companies to provide switching in long distance service. OCCs were then able to penetrate the AT&T long distance market due primarily to their own competitive prices.

In 1971 data network channels were allowed so that competition was not limited to long distance voice channels alone. The FCC attempted to draw the line between data processing and communication by applying the Computer Inquiry I ruling. Communica- tion services were to remain regulated while computer services were to remain unregu- lated. At this point it seems that the FCC was curtailing its regulatory auspices.

Through separate subsidiaries, independent telcos were able to expand into Value Add- ed Networks (VANs). That is, packet switching networks such as General Telephone Cor-

Effects of deregulation 229

poration's Telenet. Other sectors originally involved in data processing evolved into data transmissions such as McDonnell Douglas's Tymnet. AT&T, as pointed out above, was barred from the provision of data processing services because the 1956 Consent Decree restricted their services to regulated communication services.

Although the computer and microwave provided the initial technology to advance VANs, satellite communications amplified competition. With the Open Skies II decision, the FCC opened the door for OCC domestic satellite services. While the FCC restricted AT&T from using satellites for private line service for 3 years after satellite service was instituted, they were allowed to transmit their monopoly services by satellite. This ap- pears to have been an obvious attempt by the FCC to stimulate competition outside the boundaries of AT&T. Beginning with the 1956 Carterphone decision, the FCC made a series of decisions aimed at introducing competition in the telecommunications market.

The culmination of Computer Inquiry II (CI-II) and the Modified Final Judgment of the Consent Decree created the most impact today with the deregulation of CPE and the divestiture of AT&T on January 1, 1984. This marked a discontinuity in AT&T's basic philosophic strategy that had embraced regulation as a substitute for competition.

The shift of telecommunications from a regulated industry to a comoetitive environ- ment demonstrates the aim of the FCC. The success of this strategy will be marked by channel changes resulting from the FCC application of the CI-II decision and the inter- pretation of the Final Judgment as the Consent Decrees are imoleme~ted.

Channel changes and comoetitive markets

According to the Consent Decree, long distance services will continue to be provided by AT&T Communication, while the operating companies will continue to provide local exchange service within subdivisions called local access transport areas (LATAs) as shown in Figure 3. When a consumer makes a long distance ca l l - across a LATA-the consumer will select the carrier of his choice. If the consumer fails to make a selection, the BOC may by default select AT&T Communication to transmit the call. However, the long distance marketo!ace would obviously become more comoetitive if the BOCs se!ected OCCs as well as AT&T Communication to handle this traffic. It is unlikely that many of the BOCs will select OCCs in lieu of AT&T Communication because of their many years of ingrained loyalty to the parent company. Yet the prospect of l i t igation- as was the case with U.S. W e s t - m a y inspire some BOCs to proportionately distribute the ambivalent traffic among the OCCs as well as AT&T.

The OCCs face numerous other problems in their quest to obtain market share from AT&T Communication. Until equal access is available throughout the system the OCCs will be encumbered by the extra digits necessary to access the network. They also face increasing access charges for renting transport facilities. This has been complicated by the numerous legislative and judicial delays in the implementation of these changes at the end user levels. The OCC's initial market penetration was due to competitive price strategies. Even when access charges are finally implemented for residential end users, higher lease rents will make it exceedingly difficult for the OCCs to maintain competitive pricing strategies.

The OCCs face other financial allocation decisions. Funding for construction of their own transport facilities may eventually relieve them of their portion of the increasing access charges. On the other hand, this could possible divert funds away from advertising and promotional strategies needed to increase their customer base. Even if the OCCs choose a strategy to increase market share, this in and of itself, will not guarantee their continued existence.

230 Elizabeth Johnson

LAN

%

\ (ATS~T COMM) \ \ (VANs)

\ (OCCs)

o/ LATA /

J

\

I /

/ \

(LANs)

/ /

/

/ /

/ /

/

%

LATA

/o

o/ /

LATA / LATA

/ /

J I

F=gure 3 Vo=ce/Data Network Channels

The survival of OCCs may be dependent on diversification. MCI has already reacted to this reality with its entrance into cellular radio, electronic mail and Cable TV markets. It has even been able to access the data transmission market with its Cablephone service while bypassing the telco network. For the present, however, these channels will be restricted to the business sector since there are a limited number of two-way cable systems in the country. Most of these systems service the business community.

Many of the OCCs will have much more difficulty diversifying and obtaining long distance market share than either MCI or GTE Sprint. The number of long distance chan- nels that are likely to survive will be dependent upon the financial backing from a parent organization or from a resource reserve accumulated from business longevity. In the long run MCI including its new acquisit ion-Satell i te Business Systems ( S B S ) - o r Allnet, can expect to outdistance GTE-Sprint. Sprint, a utility subsidiary, is likely to find it more difficult than MCI did to develop acumen needed to acquire market share in a competitive marketplace.

Parent organizations involved in local exchange service will also be willing to invest in diversified service because of the threat of newly created channels bypassing their net- works. AT&T Communication is not required to use the facilities of the BOC's local ex- changes and would be within the requirements of its Consent Decree if it elected not to do so. AT&T and Merrill Lynch did this when they made a deal to bypass New York T e l e p h o n e - a BOC. AT&T received, for the first time, approval for a new private line

Effects of deregulation 231

tariff that allows customers to independently secure the local connections to AT&T's long distance private lines.

As fast as the OCCs are likely to integrate backward into services competitive with local exhcanges, local exchange companies are likely to integrate forward. The BOCs are likely to face encumbrances in the near future because of the separate subsidiary re- quirement of the CI-II and the requirement of a review on a case-by-case basis by the Department of Justice for any new lines of business. Nevertheless, the BOCs are rapidly expanding into new lines while challenging the necessity of the separate subsidiary requirement.

AT&T Information Systems, in a forward integration move, is already solidifying its position through acquisition of Local Area Network (LAN) channels. LANs are chan- nels that allow interface with work stations, personal computers, CRTs and mainframe computers within an organization and without contact with the telco's channel. They are dependent upon technological marriages in the PBX (switch) marketplace. As shown in Figure 3, these channels may become competitive with VANs as technological innova- tions continue in microwave, satellite and fiber optic systems.

IBM's acquisition of Rolm, a manufacturer of switches and a portion of MCI (with their option to buy up to 30o7o) is a clear signal of this possibility. AT&T Informa- tion Systems, which is the marketing arm of AT&T has also made its entrance into com- puter distribution. This is a further indication of the converging of the LAN and VAN Channels.

In the years to come, however, each of the emerging channels will face the challenge of internetting. That is a way of providing appropriate gateways and/or interfaces among networks which could not ordinarily communicate. The increasing number of packet switching companies will face the challenge of merging their protocols with LANs. This may prove to be a formidable challenge as LAN vendors orient systems for specific utiliza- tion and operations to specific customers.

The local exchange companies could become a formidable competitor since certain BOCs have been granted a conditional waiver of the structural separation requirements of the Computer Inquiry II ruling. They may perform conversion protocols from local computer systems to the standard X.25 packet-switched network protocols in facilities located in their central offices. The X.25 was defined in 1976 to conform to international conversions by the Consultative Committee on International Telephone and Telegraph (CCITT) which is an extension of the United Nations and the International Standards Organization. These BOC's separate subsidiaries are free to provide protocol conversion in the same way as the VANs. The packet-switching channels will now have competi- tion from the local exchange companies as well as the growing number of private net- works in accessing the end user.

Because service providers such as the electronic mail and data based companies may forward integrate into packet-switching in order to reach the customer base of the telcos, VANs may be forced to become more service oriented. Obviously, the omnipresence of telcos has advantages in the videotex and electronic-mail markets. With the local exchange able to provide local access points for packet networks, there is no further need for the VANs to provide thousands of access locations nationwide. They could instead forward integrate into the residential marketplace by becoming a long-distance carrier for the BOCs.

This CI-II application will also influence the demand dependency of the logistical chan- nels. New vendors may gain market access by adding the feature of X.25 capability to product lines. The distinctions between the physical and communication channels were blurred by an earlier waiver of the CI-II requirement. The FCC allowed the resale of

232 Eltzaoeth Johnson

network services (communication channels) by AT&T Information Systems and the BOCs CPE subsialarles (igotn physical channels). CI-II waivers were granted also when the FCC allowed AT&T Technologies to develop proprietary software for the exclusive use of AT&T Information Systems.

The most dramatic channel change to date resulting from the FCC modification of the CI-II rules is perhaps the reorganization of AT&T's manufacturing and marketing arms. The interim waiver will allow AT&T to vertically integrate the research, design and manufacture of CPE. It is to be expected that the BOCs will use this decision in their efforts to rid themselves of many of the requirements of the separate subsidiary.

The divestiture of AT&T from the BOCs places AT&T Technology in direct competi- tion with the BOCs both as an intermediary and as an end user supplier. In theory, but not in practice, AT&T is also one of many vendors supplying the BOCs. Although BOCs are free to select any interconnect vendor for procurement of materials, their initial ex- pertise may be as weak as that of a newborn infant's. In practice, BOCs are likely to depend upon the seven regional holding companies' (RHCs) material management sub- Sldlarles. These suosldiaries provide the procurement functions once performed by Western Electric (warehousing and transporting supplies, reviewing products, evaluating projects, repairing equipment, etc.).

If the FCC goes further and eliminates separate subsidiary requirements allowing AT&T to become a "one-step" service and equipment supplier again, then it may be possi- ble for AT&T to retain market dominance. On the other hand, single source equipment suppliers could become formidable competitors themselves in combined joint ventures with transmission service suppliers like MCI, GTE, ITT or even with AT&T itself.

Fuzure channel changes

As the changes in telecommunications channels continue it IS projected that the follow- ing will occur:

• Competition will be accepted in voice services worldwide, just as it is already accepted in equipment suppliers.

• More end products will be sold at the retail level but in outlets other than phone stores. Interconnects confined to the middle market will tend to specialize according to customer type or product line.

• While telecommunications can be relied upon more and more, there will be an in- crease In the supply of equipment that is tailored to suit the customer's particular needs. It will begin with LANS and spread throughout the network.

• Wnen or if, the integrated Services Digital Network (ISDN) is extended onto the user premises, this could provide a single interface for all communication services, thereby alleviating the existing digital leased private line service. It is likely that packet- switched digital services will not only be available for everyone, but it may eventually become the only service available.

• As regulatory involvement is reduced in competitive decision making, companies will compete through technological innovations and marketing strategies rather than legalistic maneuvers.

• Companies from noncompeting industries will merge into competing industries so that electronic services will become competitive with postal services (Electronic Mail). Newspapers and telephone companies will merge into new technologies (videotex).

• Competition between the wirebound media and the wireless media is expected to continue.

Effects of oeregu~atlon 233

• As the strtagg~e continues for dominance ~or integrated channels, an increase m the number of coahtions 0etween the interconnect suppliers and the transmission service compames such as IBM-Rolm-MCI can be expected.

• Te lecommumcat tons wall become more mgitai~zeo while computers wul continue to be more d~stributea process oriented thereoy increasing the oemand for more commumcat~ons.

• Distinctions between telephone and computer equipment will contmue to be blurred as efforts for office mtegrauon continue. These efforts will be inhibited until auto- mated offices are in place.

• Electronic media in use by banks an6 retailers will increase in or0er to communicate with, and service their customers. While computer use mcreasmg~y penetrates the private home, the number of A.T .Ms (automatic teller machines) and point-of-sale terminals is likely to multiply.

Technological changes that are beyond the tmagmation, and tecnnolog~cal changes that are already on the horizon will cause dramatic fluctuations in demand for both the logistical channels and the voice/data transmission channels. The derived demand can expect to rest eventually upon the logistical channels as a large number of services are developed and made available. Unless the channels emerge unified and there is a h~gh possibility of this happening, the logistical channel will revert to its supportive stance.

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