The Regional EconomistJuly 1995

I Want Myby Adam M. Zaretsky

MTV• • •

The Cable TV Industry and Regulation

and My CNNand My ESPN

and My TBS

and ...

A s if editing a movie onceagain because the last cutwas not just right, the U.S.Congress is considering

deregulating the cable televisionindustry after re-regulating itjust three years ago. This followsthe initial deregulation of thecable TV industry 10 years ago.Much of the regulatory volatilitysince 1984 arose because of greatleaps in technology and changingopinions about what other indus-tries or forms of entertainmentcompete with cable TV. Regardlessof the reasons, however, the on-and-off nature of regulation inthis industry makes it a case studyof the economics of regulation,with particular attention to theconcepts of barriers to entry, rateregulation and natural monopoly,all of which play an importantrole in this industry.

A Cable RetrospectiveCable television began in the

1940s as a way to bring broadcasttelevision signals to remote areaswith poor reception. By the 1960s,cable operators started importingsignals from stations in distantcities in the hope of attractingcustomers with greater variety.Perceiving these imported signalsas a threat to their market shares,local broadcast stations petitionedthe Federal Communications

Commission (FCC) to intervene ontheir behalf. The FCC, favoring thelocal broadcast signals, restrictedthe cable operators' ability to importdistant signals. At the same time,it instituted its "must-carry" rules(see glossary for definitions ofcable terms).

The FCC's control over cablesystems greatly increased in 1972when it adopted a new set ofcomprehensive rules specifyingminimum technical standardsand franchise requirements. Atthe same time, the FCC pre-emptedstate and local regulation of paycable services, established ceilingsfor franchise fees and relaxedthe restrictions on importingdistant signals, as long as theywere taken from the closestTop-25 market. By the late 1970s,a series of adverse court rulingsand the commission's morepro-competitive stance led tothe removal of many of theserestrictions.

The FCC was not the onlyagency with which these cablecompanies had to deal, however.A myriad of state and local regula-tions covering basic cable servicescreated a complex working envi-ronment for any company operat-ing in multiple communities acrossthe country. This environmentmade cable TV deregulation anatural and extremely importantpart of a larger telecommunicationsderegulation package in the 1980s.1

This move to allow the market toallocate resources in this sector ofthe economy culminated with the

Cable Franchise and Communica-tions Policy Act of 1984 (CableAct of 1984), which effectivelyderegulated cable TV.

Glossary of CableTV Terms

Basic cable service:includes re-transmission oflocal TV channels, but mayalso include such cable chan-nels as CNN, ESPN, C-Spanand "superstations," offeredas a single level of serviceor as two or more "tiers"of service.

Cable system penetration:the total number of subscribersdivided by the number ofhomes accessible to cable.

Franchise fee:the licensing fee paid tothe cable system's governingmunicipal authority. Cablesystems cannot operatewithout a franchise.

Must-carry rules:require cable systems to carrythe signals of all TV stationslicensed to a communitywithin 35 miles.

Pay cable service:refers to premium channelslike HBO or Showtime that areusually scrambled and requirea decoding box to view.

Cable Prices andRegulation

Regulation Off...andOn Again

The Cable Act of 1984 had threemain provisions: It 1) removed therate restrictions for basic cable TV ser-vice in communities where operatorsfaced "effective competition" fromother media; 2) restricted the abilityof local franchise authorities to denyrenewals to firms when their contractsexpired; and 3) permitted local fran-chise authorities to require that somechannel capacity be devoted to public,educational and governmental use.The FCC defined "effective competi-tion" as the availability of three ormore, unduplicated, over-the-airtelevision channels—for example,ABC, CBS and NBC—in the cablesystem's market area. Based on thisdefinition, about 97 percent of all

As the chart above illustrates,cable prices increased dramaticallyduring the period of deregulation,then moderated somewhat underre-regulation. The moderationwas not as striking as anticipated,though.

cable systems were free from rateregulation by Dec. 29, 1986, theeffective date of deregulation.

Market Forces Take OverAfter deregulation, many changes

occurred in the cable industry, notthe least of which were price hikes.As then-Sen. Albert Gore Jr. put it:"Precipitous rate hikes of 100 percentor more in one year have not beenunusual since cable was given totalfreedom to charge whatever the mar-ket will bear.... Since cable was dereg-ulated, we have also witnessed anextraordinary concentration of con-trol and integration by cable operatorsand program services, manifestingitself in blatantly anticompetitivebehavior toward those who wouldcompete with existing cable operatorsfor the right to distribute services"(Congressional Record, May 18,1989). Gore's sentiments werelater supported by findings in bothgovernment and academic studies.

According to a 1990 GeneralAccounting Office (GAO) report,the average rate for the lowest tierof basic service increased 43 percent—from $11.14 to $15.95 per month—between Nov. 30, 1986, and Dec. 31,1989. For this higher rate, the sub-scriber received an average of sevenadditional channels (from 24 to 31).During the same period, the averagerate for the most popular level ofservice increased 39 percent—from$11.71 to $16.33 per month. Thissubscriber also received an averageof seven additional channels (from27 to 34). In comparison, theConsumer Price Index rose about14 percent between December 1986and April 1991.

As cable prices increased rapidly,cable TV, during these first threeyears of deregulation, became avail-able to 14 percent more homes thanpreviously. Just a small number ofthe newly accessible homes choseto subscribe, however, and cablepenetration rates increased by only2 percentage points to 58 percent.(See the accompanying map for cur-rent cable penetration rates by state.)

In a follow-up report in 1991,the GAO reported that the averagerate for the lowest tier of basicservice increased another 9 percent—to $17.34 per month—betweenDec. 1, 1989, and April 1, 1991.With this higher rate, the subscriberactually lost one channel previouslyreceived, making the average numberof channels received 30. Duringthe same period, the average ratefor the most popular level of serviceincreased another 15 percent—to$18.84 per month. This rate gavethe subscriber one additional channel,making the average number of chan-nels received 35. In comparison,the Consumer Price Index rose about7 percent between December 1989and April 1991.

The GAO also noted that, duringthis year and a half, the number ofcable companies offering more thanone tier of basic service increasedsharply—from 17 percent to 41 per-cent. Typically, cable companiesbegan offering a basic package—justthe major networks and one or twodistant channels—and an "expanded"tier that included the rest of the com-monly viewed cable channels, likeCNN or ESPN. This change was areaction to proposed legislation inthe early 1990s that would havere-regulated only the lowest-pricedtier of basic service. In fact, the finallegislation that was passed and signedin 1992 did just that.

In response to the rate hikes expe-rienced after deregulation, the FCCin June 1991 actually beat Congress

6

! Regional EconomistJuly 1995

to the punch and redefined "effectivecompetition" to try to increase thenumber of cable systems that wouldbe subject to rate regulation. Itdid so very simply by increasingthe required number ofunduplicated, over-the-airbroadcast signals in thesystem's area from threeto six. It also decreedthat effective competitionwould exist if anothermultichannel service—a cable system or homesatellite dish, for example—available to at least50 percent of the homesaccessible to cable TV,had at least 10 percentof these homes subscribing.This redefinition, though,would only affect about41 percent of the cablesystems, which serveabout 20 percent ofthe nation's subscribers,according to the GAO's1991 report.

Is Re-Regulation theAnswer?

Sometimes lost amongthe bits of informationabout price hikes andchannel availabilityis the fact that people willinglychose to pay higher prices for cableTV. One of the original argumentssupporting deregulation was thatenough substitutes existed to fostercompetition in the market withoutany government intervention.To try to quantify the effects ofthese options on the industry,researchers looked at demandpatterns and elasticities—measuresof how the demand for a productor service responds to changes inprices—for cable TV and its substi-tutes and complements.

Mayo and Otsuka undertooksuch a study to compare consumerdemand for cable TV both beforeand after deregulation. One of theirfindings was that at the prevailingprice levels in the early 1980s (beforederegulation), the demand for basiccable service was generally inelastic—not very responsive to price changes—while the demand for pay serviceswas generally elastic—quite respon-sive to price changes. This suggeststhat prices for basic cable servicecould increase without much loss indemand, while similar price increasesfor pay services would lead to sharpdeclines in demand. This conclusionis further supported by Rubinovitz,who found that there was no changein the demand elasticity for eitherbasic or pay cable services between

regulation and deregulation. Thismeans that even though the environ-ment in which cable systems operatehad changed, the fundamental demandstructure of the market had not.

Cable Penetration RatesSeptember 1994

Mayo and Otsuka also foundthat the demand for basic servicein rural areas was generallyinelastic, while the demandin urban areas was generallyelastic. This makes intuitivesense: Consumers are betterable to receive over-the-airbroadcast signals in urbanareas than in rural areas,which, in turn, suggests thatthe demand for cable servicesin urban areas should be moresensitive to price changes.Finally, the authors showedthat the regulation of basiccable rates in the early 1980sled to prices that were abovemarginal cost, but below thelevels that would have prevailedhad the regulation been eitherabsent or completely nonbinding.This last finding is evidence ofa natural monopoly (see sidebaron the following page).

Carroll and Lamdin alsofound that the cable industry is anatural monopoly and argued thatthis finding is consistent with state-ments from cable industry executives,who generally lobby against rateregulation. The authors inferred fromthese statements that the executiveseither believe that their industryfaces effective competition, so thatno rate regulation is needed, or know

Eighth DistrictPenetration Rates

DesignatedMarket Area

Bowling Green, KY

Columbia-Jefferson City, MO

Evansville, IN

Fort Smith, AR

Jackson,TN

Jonesboro, AR

Little Rock-Pine Bluff, AR

Louisville, KY

Memphis, TN

Paducah, KY/Cape Girardeau, MO/Harrisburg-Mt. Vernon, IL

Quincy, IL/Hannibal, MO/Keokuk, IA

Springfield, MO

St. Louis, MO

Rate

53

56

58

62

59

67

58

60

58

55

56

47

50

7

CABLE TV Market?Why Regulate the

O ne of Congress' goalswith cable TV deregulationwas to increase competi-

tion and provide for an orderlytransition from regulated to com-petitive markets. By increasingcompetition, Congress hoped tospur innovation and new services.But if deregulation increasescompetition and spurs innovation,then what economic purposecould regulation have served inthe first place?

Natural MonopoliesThe most common reason to

regulate an industry is becauseit is a natural monopoly. In anutshell, this means that thefirm's costs of production growsmaller as the level of outputrises because of large economiesof scale. Economies of scale existwhen most of a firm's productioncosts are fixed and incurred up-front, implying that it can supplyadditional customers withoutincreasing its costs by much. Infact, the firm's marginal cost ofproduction—the cost incurred toproduce the last unit of output—actually declines as it producesmore. As the firm's marginal costdeclines, so does its average cost.This creates a barrier to entry inthe market: One large firm ismore efficient at producingany level of output than a setof smaller firms competing witheach other. This scale of efficiencyessentially prevents another firmfrom entering the market andeffectively competing with theestablished firm. Public utilitiesare an obvious example: Once anelectric company has establishedits network of lines, it would becostly and inefficient for anothercompany to enter the market andset up a system of parallel lines.

A natural monopoly, like mostfirms in the economy exists to earnprofit. To maximize this profit,it carefully chooses how much to

produce, based on demand andproduction costs. In practice,however, the profit-maximizinglevel of output of a naturalmonopoly generally falls belowthe level of service demanded bythe community. Therefore, thegovernment usually intervenes.

The government's problem isto decide how much to allow thisregulated firm to charge for itsproduct. Economic theory tellsus that efficiency occurs when theprice charged equals the marginalcost of production. This pricingscheme will not work in a naturalmonopoly, however, because itsdeclining costs imply that marginalcost is always less than averagecost.1 Setting the price at marginalcost will earn the firm less thanits average cost of producingeach unit of output, causing thecompany to lose money on eachunit. A solution, then, is to letthe firm charge a price greaterthan marginal cost, preferablyits average cost.

Is the Cable TVIndustry a NaturalMonopoly?

The rationale for regulating thecable TV industry has generally beenthat it is a natural monopoly. Onlyafter deregulation, though, wereanalysts able to observe the marketwithout government rate restraintto determine if this supposition wascorrect. The findings from thesestudies did show that after deregu-lation in 1984, the cable TV indus-try began to exercise market power(it acted as a monopoly), leadingto price increases greater than thoseanticipated at the time of deregu-lation.2 In fact, Rubinovitz foundthat 43 percent of the price increasein cable TV rates after deregulationcame from an increased exerciseof market power. Cost and qualityimprovements appear to explainthe rest of the increase.

1 To understand this idea, think of a student'sreport card. The grade point average is anal-ogous to average cost, while the grade inany particular class is analogous to marginalcost. If the student has a "B" grade pointaverage, and then receives a "C" in a class,the grade point average will fall. In otherwords, whether the marginal grade is greateror less than the average determines howthe average will move. The same is truefor marginal and average costs.

2 See, for example, Carroll and Lamdin (1993),Rubinovitz (1993) and Mayo and Otsuka(1991) for findings that cable TV companiesacted as monopolists after deregulation.

that their industry has monopolypower, so that no regulation is desired.To further support the natural monop-oly conclusion, Carroll and Lamdinalso discovered that the prices of cablecompany stock declined in responseto announcements of lower entry bar-riers, which further suggests elementsof natural monopoly and supports thenotion that regulation would promoteefficiency in the industry.

Deregulation in the Offing, Again?Just three years since cable televi-

sion's re-regulation in 1992, debate toderegulate has already begun, fueledby great advances in technology andthe desire of the seven regional tele-phone companies (or Baby Bells)to enter the market. The proposedTelecommunications Competitionand Deregulation Act of 1995 (Senatebill) and Communication Act of1995 (House bill) would not onlyremove the current rate regulation,but also allow other industries tooffer consumers the type of videoservices currently available onlyfrom cable companies. The BabyBells have already sought courtapproval for entrance into the cablemarket, buoyed by the merging ofvoice and video into a single system,which is close to becoming a techno-logical reality. The National CableTelevision Association, pointing to thearrival of new TV signals via satellitedish, telephone line and wirelesstechnology, supports deregulationbecause, "Consumers have a choicefor TV that didn't exist before."2

These bills would remove barriersto entry in the cable industry, allowcable operators to provide telecom-munications services, and allowcross-ownership between providersof common carrier video program-ming (like telephone companies)and cable companies. The Baby Bellsacknowledge, however, that even ifthey were allowed to enter the cablemarket today, they are still two tothree years away from offering wide-spread video services. Thus, the mostthreatening competition to the cableindustry will probably not appearfor at least 24 months.

Effective deregulation could occurbefore passage of this legislation,though, if the FCC chooses to redefine"effective competition" again. Sucha move would potentially reduce thenumber of cable systems that aresubject to rate regulation. Currently,effective competition exists if less than30 percent of the households in thesystem's area subscribe, or if anothermultichannel service, available toat least 50 percent of the cable-readyhomes, has at least 15 percent sub-scribing.3 Whether the legislation

passes or not, the FCC will still havea role in determining if a cable sys-tem's rate for service is reasonable.Essentially, if a rate "substantiallyexceeds" the national average forcomparable cable service, the FCCcan intervene.

More for Less, That'sWhat We All Want

With or without regulation, thecable industry will be very differentfive or 10 years from now. The BabyBells will probably be allowed to enterthe cable market and will probablyoffer video services that even cablecompanies will not because of theinteractive and switching technologiescurrently available in the telecommu-nications industry. Until this typeof competition arrives, though, thequestion of whether cable televisionshould remain a regulated industryis difficult to answer.

Recent studies have shown thatelements of natural monopoly doexist in the industry, supporting thenotion that regulation might still bejustified. Cable companies, on theother hand, point out that duringderegulation the industry experiencedgreat advances in technology andofferings. Were these advances worththe cost to achieve them? In otherwords, were the higher rates paidduring deregulation worth the out-come? Many would say yes. Andmany actually did say yes by contin-uing their cable subscriptions.

Opponents of deregulation arguethat even though regulation is notideal, true competition does notyet exist; thus, why give the indus-try the best of both worlds: nocompetition and no rate restrictions?Subscribers paid the higher rates,they argue, because there were noviable alternatives.

Which is the best outcome forthe market? There is no simpleanswer. But it looks as if we mayhave to wait and see if other indus-tries, like telephone companies, enterthe cable market with comparablevideo services. If they do, we willprobably see great improvementsin service and offerings without thegouging price hikes many fear.

Adam M. Zaretsky is an economist at the FederalReserve Bank of St. Louis. Thomas A. Pollmannprovided research assistance.

THE Regional EconomistJuly 1995

ENDNOTES1 Recall that in the early 1980s,

AT&T was still the only companyin the country offering local andlong-distance telephone service.Deregulation was also occurringin many other industries—forexample, trucking, airlines andbanking—during this period.

2 See Robichaux (1995).3 This latest revision of the defini-

tion occurred in April 1994.

REFERENCESCarroll, Kathleen A., and Douglas J.

Lamdin. "Measuring MarketResponse to Regulation of theCable TV Industry." Journal ofRegulatory Economics (1993),pp. 385-99.

Fournier, Gary M., and Ellen S.Campbell. "Shifts in BroadcastPolicy and the Value of TelevisionLicenses." Information Economicsand Policy (1993), pp. 87-104.

Mayo, John W., and Yasuji Otsuka."Demand, Pricing, and Regula-tion: Evidence from the CableTV Industry." RAND Journalof Economics (Autumn 1991),pp. 396- 410.

Prager, Robin A. "The Effects ofDeregulating Cable Television:Evidence from the FinancialMarkets." Journal of RegulatoryEconomics (1992), pp. 347-63.

Robichaux, Mark. "Cable IndustrySays New Rivals Obviate Rules."Wall Street Journal (April 3, 1995).

Rubinovitz, Robert N. "MarketPower and Price Increases forBasic Cable Service SinceDeregulation." RAND Journalof Economics (Spring 1993),pp. 1-18.

U.S. General Accounting Office.Telecommunications. Follow-UpNational Survey of Cable TelevisionRates and Services, GAO/RCED-90-199 (June 1990).

. Telecommunications.1991 Survey of Cable TelevisionRates and Services, GAO/RCED-91-195 (July 1991).