Natural Monopoly. For over a hundred years, the Bell System held this distinction, and was then shattered into 8 pieces. Why did the federal government mandate divestiture of the telecommunications giant American Telephone and Telegraph in 1984? More importantly, why didn't it do so before the 20th century even began? Beginning on a teacher's workbench, the Bell Company's miraculous survival, and its subsequent appointment to government regulated monopoly is unfathomable.
American Telephone and Telegraph was never a "natural" monopoly. Politics, court decisions, and out-of-court settlements, as well as ruthless anti-competition actions on the part of the company permitted its position as a monopoly despite the fact that economics did not dictate that a single company is more efficient than competition, and consequently unfairly charged higher prices than necessary while holding back the technological progress of the industry, both of which are costs to consumers. Three important factual considerations are necessary to support the claim. The first is an understanding of the concept of a natural monopoly not as a vague notion but as a rigorous economic model. Second, the Bell Company's reliance on external factors to preserve a system which does not fit that model. Last, empirical evidence both from Bell's early years before its monopoly status and after divestiture in 1984 validate this claim. Additionally, other markets that faced similar developments offer further evidence that phone service was never a natural monopoly.
Every firm incurs a cost C that varies with its (positive) output quantity q. The cost function C(q) of a firm is this relationship between cost and quantity. Traditionally, economies of scale have been the major focus of the natural monopoly debate; if the average cost AC=C(q)/q has a negative slope for all q, then AC(q1 )>AC(q2) if and only if q2>q1. If every firm has the same cost function, this implies that if a demand d exists, the AC(d) < AC(d1) + AC(d2). In other words, the sum of two firms costs producing a portion of the total goods is larger than the cost of a single firm producing it. This property is known as subadditivity. a requirement for a natural monopoly that at first may seem more strict than economies of scale, but all functions which have economies of scale satisfy subadditivity, while not all subadditive functions have economies of scale. (Sharkey 59)
All monopolies set their prices to maximize profits without concern for any other players; no other firm can influence them. Profit maximization for a monopoly occurs when marginal revenue equals marginal cost. Monopolies face a downward sloping demand curve; for any given price, a monopoly can sell a given quantity of goods, and if it raises its prices it will sell less. The only way to sell more than that quantity is to lower prices. The arbitrary decision to set output where marginal revenue equals marginal cost will not necessarily meet demand.
Profit maximization of all monopolies requires close inspection of any firm suggesting that it is a natural monopoly. Certain goods are so valuable that it is society's best interest to have more produced than the profit maximizing level. The classic example for this is water; should low-income areas be denied running water simply because they cannot afford it? Typically, monopolies provide to such areas by using price discrimination and multi-part pricing. Universities often give financial aid to those who cannot afford high prices, an example of price discrimination. Many people feel price discrimination is unfair. Multi-part pricing includes the installation fee for cable television, plus monthly charges for a basic package, additional monthly charges for premium channels such as HBO or Showtime, and further one-time charges for each use of Pay-Per-View. Multi-part pricing allows customers who can afford to pay receive better service than those who cannot thus satisfying any questions of fairness while providing at least minimal service for all.
Subsidization can also allow a monopoly to sell products at a price other than its profit maximizing price. Essentially, government subsidization permits price discrimination indirectly by taxing people at different rates according to income. These funds enable the monopoly to sell output at a price below the profit maximizing price, or even below cost, thus benefiting society.
Theoretically, a monopoly can benefit society at an acceptable cost and receive profit in return. In a market with a subadditive cost function, a monopoly maximizes economic efficiency and therefore receives the distinction of being a natural monopoly. Yet many industries which have economies of scale have not developed into monopolies. Most notable is the automobile industry, which not only exemplifies economies of scale but to a large degree perfected it. Differentiability of brands in consumer electronics keeps the market just shy of perfect competition despite the importance of economies of scale. Other factors play varying roles.
Sunk costs are an important consideration. Railroad lines represent an irretrievable expense on the part of the company that laid them. If several companies lay lines in the same area and then suffer a slump in demand, there is an over-capacity that cannot be utilized. Consequently, all of the companies will take sever losses during this time but may not be able to recoup those losses when demand rises again. Maintenance, safety inspections, salaries, and interest payments drain all of the firms despite the inability to turn a profit. Many go bankrupt. This destructive competition hurts firms and their employees, but also hurts consumers when companies go under, tracks are in disrepair, or service to some areas is cut. A single firm, however, could weather the storm knowing that when demand rises again it can reap profits without fear that other firms will steal its business. Most industries given the distinction of natural monopoly like utilities, including the telephone are capital-intensive and have large sunk costs.
"There is a natural monopoly in a particular market if and only if a single firm can produce the desired output at lower cost than any combination of two or more firms." (Sharkey 54) This simple state takes into account subadditivity, as well as long run factors like sunk costs and the ability to use multi-part pricing or price discrimination. With respect to Mr. Sharkey, this definition should in fact read "… if and only if a single firm does produce the desired output at a lower cost…" There are several reasons why even given subadditivity and tricks to increase output above the profit maximizing quantity a natural monopoly might not have lower costs than multiple firms. The key reason for this is that subadditivity assumes that all firms have the same cost function, which is clearly not the case.
One of the most well-known monopolies in the world, the American Telephone and Telegraph Company argued for over a century that the telephone industry was a natural monopoly. A clear understanding of what a natural monopoly is and how it functions enables close investigation of this claim.
The initial Bell Company rested on the foundation of patent number 174,456. Alexander Graham Bell received it after over five years of research with assistant Thomas Watson. Their work was funded by Gardiner Hubbard and Thomas Sanders, who probably never expected to see their money again. Often cited as the most valuable patent ever awarded, legal disputes raged heavily in part because of its value and partly because Bell filed for it before the working device existed. There were no less than six hundred lawsuits during the 17 years it gave the Bell Company the sole right to produce telephones. Of these suits, the closest Bell ever came to losing was a 4-3 U.S. Supreme Court decision in favor of Bell over Daniel Drawbaugh, who claimed to have invented the telephone in 1867. Bell filed for his patent on February 14, 1876 and received it less than a month later on March 3. March 10, Bell uttered the now-famous phrase, "Watson, come here. I want you," over his first working telephone.
The first incarnation of the telephone can only be described as primitive. Background noise, poor transmission quality, and a lack of interconnectivity rendered it a device suitable only for entertainment. Bell went on a lecture tour, charging 50 cents for admission to demonstrations of the telephone as a technological curiosity, rather than marketing it as the necessity we consider it today. Most of the initial telephones came in matched sets; a buyer would connect his home to his business, for example, without the ability to call anyone else. Without shouting, the other party was almost certain not to hear you. In April of 1877, there were 6 telephones. With the publicity gained from the lectures, that number rose dramatically to over 3,000 by the fall. An exceptionally important transition came during this time when the first switchboard was installed in New Haven, Connecticut, the first hint of the telecommunications web that now spans the globe. In order to make sure the business ran smoothly, Hubbard and Sanders founded incorporated The New England Telephone Company, the earliest incarnation of the giant AT&T. At this point, Hubbard and Sanders made the brilliant decision to lease rather than sell phones. A cornerstone of the Bell System from its inception to the breakup in 1984, leasing phones gave Bell a powerful edge and enormous profits.
Naturally, many other companies tried to compete with New England Telephone. Drawbaugh, despite his ability to sway (not quite enough) judges, never presented a serious threat. The most dangerous enemy was Elisha Gray, who filed for a caveat in January 1876, which was denied when Bell received his patent. The timing was critical; Gray went in to file for his patent just hours after Bell walked out the same building with his priceless piece of paper. The competition began when Western Union bought the rights to Gray's invention and hired no less a man the Thomas Edison to improve it.
Western Union already had a monopoly on the telegraph business. In September if 1877, Hubbard offered to sell the New England Telephone Company to Western Union for $100,000. They declined. When Gold and Stock Telegraph Company a wholly owned subsidiary of Western Union stopped using telegraphs and replaced all their equipment with Bell telephones in March 1878, Western Union realized that they may have made a mistake. They offered $1,000,000 for the Bell Company and were flatly turned down. This prompted the decision to buy up competing devices and hiring of Edison for R&D, a decision which improved the telephone's quality tenfold; Edison invented a carbon transmitter vastly superior to the transmitters being used in Bell's telephone, allowing users to talk in a normal voice rather than shouting.
Responding in kind, Hubbard hired veteran businessman Theodore Vail, perhaps one of the most influential CEOs in history. Easily as important as Henry Ford or John D. Rockefeller, Vail is not only responsible for the tremendous growth of AT&T but also its position as a monopoly and authored long-standing view that it should be so. Before this, however, he had to fend off Western Union's onslaught. He purchased rival patents for carbon transmitters and filed suit against Western Union. A deadly opponent, Western Union denied the Bell Company its line right-of-ways, preventing Bell from entering many areas.
Against the inventiveness of Thomas Edison, Vail was prepared to pit the deviousness of Jay Gould, who offered to build a telegraph company for the Bell System to attack Western Union on its home turf. Before this deal with the devil could be consummated, the U.S. Supreme Court again made a far reaching decision; Western Union was barred from competing in the telephone industry and would sell its 56,000 telephones for 20% of Bell's profits over seventeen years. Western Union also sold Western Electric a telephone manufacturing company it had bought from Elisha Gray to the Bell Company, which was barred from the telegraph industry. With this court decision, Bell was assured a monopoly for seventeen years based on patents.
In 1879, the New England Telephone Company became the National Bell Telephone Company and changed to the American Bell Telephone Company a year later. These helped nullify franchise contracts signed in the early stages of development. Western Electric sold all its equipment to Bell at cost, and Bell bought everything Western Electric made. Equipment was important for the Bell company, and this close relationship gave them a distinct weapon. Combined with the policy of leasing and never selling, Western Electric is largely responsible for the enormous success of the Bell Company. Until 1893, when the paten expired, investors received annual dividends around 15% of their investment. In 1885, $1,500,000 in dividends was paid out of $3,000,000 returns, without concern for public protest over ugly telephone lines criss-crossing the city skies or clamoring for service in areas that Bell had not yet reached. Theodore Vail, disgusted with the shareholders apathy towards expanding and improving the company, resigned before the original patent expired.
Before he left, Vail had created a vision of how the Bell System should look at how it could accomplish that goal. He bought up any independents he could, and starved the rest. No non-Bell company was permitted to link to the Bell System. New contracts were signed with franchisers only if Bell received a generous portion of the stock. Every conceivable device used to support the telephone was patented to make sure any independents had inferior and incompatible systems. Even when a local independent was successful, they could not compete with Bell's increasingly important long-distance service.
Still, when the original patent for the telephone expired, all-out war was declared. Bogged down with paying royalties to the Bell Company on equipment, franchise operators could not compete with new independents. In order to make dealing with an independent seem more attractive to consumers, technical innovation was a cornerstone of the independent attack. The dial system was invented by and used by independents before Bell, ending the era of asking the operator to complete your call. Of course, Bell's monopoly pricing became an albatross around the companies neck; in Lansing, Michigan in the early 1900's, Bell was charging $48 and $40 a year for business and residential service, respectively, versus an independent's price of $24 and $36. The competition hurt; Bell's revenue was $88 per telephone station in 1885, $63 in 1890, and $43 in 1907. While reorganizing to fight this onslaught, the Bell Company became American Telephone and Telegraph in 1897.
Though AT&T suffered, the consumers benefited; Bell had only 266,431 in 1894 when the patent expired. A decade of competition increased that number to 1,317,178 while the independents had 1,053,866. Lower prices, better service, automatic dialing, improved maintenance, and more accessibility prove that competition worked. It may have been, as Theodore Vail loved to say "destructive competition." Dominant but rivaled in 1904, AT&T would eventually reassume the throne unchallenged.
Cut off from Bell's long distance systems, unable to match Western Electric's at-cost pricing, and unable to match Bell's short-run strategy of pricing below cost to gain market share, the independents crumbled. AT&T also aggressively purchased stock in companies in order to shut them down. In companies where they had controlling stock, they would encourage minority shareholders to sell by suspending dividends, diverting all profits into maintenance and depreciation. Propaganda helped to lower the market value of stock and simply pressuring minority stock owners to sell at low prices helped AT&T gain control of even the healthiest independent. Only a few scattered companies remained outside AT&T's control.
All of this required money, and lots of it. Boston, the original home of the Bell Company, did not have the financial market to support it, which is the main reason for the move to New York and the name change to AT&T. Borrowing large amounts of money for expansion, Bell's sales increased from $6,000,000 in 1896 to $630,000,000 in 1906. Despite this unchallenged market dominance, investors began to worry about the long-term stability of the firm and persuaded Theodore Vail to come out of retirement and again head the Bell Company. This deep connection with the New York financial markets turned out to be a very powerful ally for AT&T.
The Erie Telephone & Telegraph Company did manage to control the phone industry in seven states with a long-distance system connecting them. A group of New York investors decided to purchase Erie T&T and launch a national competitor to AT&T. But J.P. Morgan himself had millions in AT&T and threatened that there could be drastic consequences for any firm that financially supported the new venture, and thus it died. AT&T took over a bank loan Erie T&T owed and couldn't repay, and yet another independent company came under the control of the unstoppable AT&T giant. While this may have been the most spectacular story of AT&T's financial influence over competitors, it was par for the course. Only small, local companies that could be supported by local banks could borrow money; the major financial institutions were closed to all firms but Ma Bell. Without long-distance or a large customer base, local independents could not match AT&T's ability to cross-subsidize or offer access to the all-important phone network outside a small area, and so slowly starved to death.
Often when small-town independents died, Bell Company employees would hold a bonfire in the town square or other public area, demonstrating the futility of competing with AT&T and purging the world of non-Western Electric equipment. These brutal tactics backfired in many rural areas; many farmers would opt for bare wires strung across fences connecting pathetically out of date phones that only occasionally worked rather than "sell their sole to devil" masquerading as the phone company. These rural independents survived, but they too served the whim of AT&T; Vail viewed them as an excellent deterrent to anti-trust factions, saying in a letter to Senator W. Crane of Massachusetts that Ohio and Pennsylvania independents "do not affect out business and satisfy the small number of people who desire competition." (Goulden 71-72)
Through all of this, various agencies attempted to intervene. A court agreement in 1912 required AT&T to connect to other companies, but little actually resulted. In San Francisco in 1906, AT&T attempted to bribe the city legislature into shutting down a competitor, and several high-ranking Bell officials were jailed to no avail; they were released on technicalities. Finally, the U.S. Justice Department stepped in, but the passage of the Kingsburry Commitment on December 19, 1913 was a bit like closing the barn door after all the horses ran away. Named after AT&T vice-president J.E. Kingsburry who developed the agreement with Attorney General George Wickersham, the Kingsburry Commitment stated "Bell would not acquire, directly or indirectly, control over any competing company and that Bell would connect its system with independents, provided the companies' equipment met Bell's operating standards." (Goulden 72) In addition, AT&T left the telegraph business permanently, selling the controlling interest it had acquired in Western Union. Consequently, those independents who tired of futily tilting at the AT&T windmill could not even sell their business, since Bell was the only one buying. This was the only real consequence of the agreement, and in 1921 the Justice Department voided the agreement.
The parties most hurt by Bell's expansionary and anti-competitive behavior were farmers. From 1920 to 1940, the number of rural phones dropped by almost 40% to 1.5 million. Certainly the Great Depression explains part of this decline, but Bell's rates did not decline in response to this economic crisis. Indeed, AT&T maintained a $9 per year dividend over the almost same period. Bell in fact raised its prices and encouraged independents to do the same by charging interconnection and long-distance access charges. Independents had to charge enough to at least meet this fixed cost.
The market was controlled purely by AT&T, without any legal appointment to the position of monopoly. Patents protected the Bell Company, to be sure, but control of long-distance and backing from the major financial markets, along with sheer size, were the only real reasons AT&T maintained dominance. If this monopoly was in fact natural, than C(q) for AT&T must be lower than the sum of other companies cost functions, but there is almost no data to available to test this claim. Clearly, however, competition forced AT&T to expand and improve service. The end of competition cost consumers an amount we will never be able to ascertain, but some theoretical considerations can help determine whether or not AT&T produced output at a lower cost than a perfectly competitive environment would, a point to be addressed later.