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The Rise of AT&T

The Invention of the Telephone

On December 31, 1983, the day before AT&T was broken up, it was the largest corporation in the world. It dominated the four major markets in telephony: long distance, local service (or local loops), customer premises equipment manufacture, and switching and transmission gear manufacture. Based on its technological leadership, AT&T could probably have been a major factor in a variety of other industries, such as motion picture equipment, radio and television broadcasting, and consumer electronics. But the restrictions imposed by various government decisions on the company precluded AT&T from becoming an even larger company. Yet its beginnings were quite modest.

Alexander Graham Bell was a teacher of the deaf and an experimenter who consciously became interested in the development of a “speaking telephone.” Bell was in competition with Elisha Gray, another brilliant inventor, to see who would be the first to develop a speaking telephone. Both men had strong financial backing and encouragement from scientists. Many other inventors were also engaged in the pursuit of developing a voice-grade telephone, and after Bell’s victory some of them claimed that his patents were invalid because their inventions preceded his.¹

On February 14, 1876, Bell filed his basic patent application for a telephone transmitter employing a magnetized reed attached to a membrane diaphragm—an apparatus capable of transmitting sounds and changes of pitch, but not speech. Nevertheless, the patent application, like others drafted by skilled patent lawyers, was sufficiently broad to cover other apparatuses for transmitting speech. Only several hours later, Elisha Gray arrived at the Patent Office and filed a caveat (notice of pending patent application) for a method of transmitting and receiving speech, but there is considerable doubt whether Gray’s instruments would have conveyed speech. In any event, it was not until March 1876-almost a month after the filing of the patent application—that Bell was able to convey the famous words over a telephone to his assistant: “Mr. Watson, come here; I want you.”

The events surrounding the filings on the same day and the suspicion that Bell might have unlawfully seen Gray’s caveat to amend his original application together with the claims of many others that they had invented the telephone led to much litigation. Nevertheless, the 1876 basic process patent (and Bell’s 1877 basic receiver patent) withstood approximately six hundred lawsuits and patent interference proceedings, including a suit brought by the United States for patent cancellation.² In 1887 a divided Supreme Court upheld Bell’s claim against five challengers. While doubts about the circumstances will always remain and one may quarrel with the patent laws, the weight of evidence and authority supports Bell’s claim. However, AT&T’s enemies continued to claim that the patents were unlawfully obtained and upheld by a conspiracy embracing a majority of the Supreme Court, patent examiners, and numerous circuit court judges. The furor is understandable considering that the basic telephone patents were the most valuable in history.

The First Era of Telephone Competition

Prior to his patent filing and invention of the telephone Bell and his partners, Boston businessmen Gardiner Hubbard and Thomas Sanders, formed the first predecessor enterprise to AT&T on February 27, 1875. Under the Bell Patent Association’s agreement, Hubbard and Sanders would supply the capital and all would share equally in any patents Bell might obtain. Hubbard offered to sell for $100,000 the 1876 patent to Western Union shortly after it was filed, but was turned down because Western Union’s management believed that the telephone was impractical. By November 1877 Western Union recognized that it had blundered and organized a subsidiary called the American Speaking Telephone Company. Western Union, then far superior in resources to the Bell enterprises, acquired several telephone patents (including Gray’s) and employed Thomas A. Edison, already recognized as a brilliant inventor, to develop telephonic inventions. Thus, the first era of competition in the telephone industry had begun.

Not only was Western Union armed with a deep pocket that would allow it to easily undercut Bell rates but, moreover, most of Western Union’s equipment and technology was at the time superior to Bell’s. Accordingly, the Bell interests could do battle in two ways: They could develop or buy superior technology, and they could bring a patent infringement suit. The suit was brought before a court in September 1878 and was settled in November 1879. Under the terms of the settlement, Western Union agreed to withdraw from the telephone business, in exchange for which it would be paid a royalty of 20 percent on all telephones used in the United States. Western Union also agreed to assign existing and future telephone patents to National Bell, then the Bell interests’ company. The agreement was to end at the expiration of the basic Bell patents in 1893–94. The first era of telephone competition ended shortly after it began.

Why had it ended so abruptly? First, contrary to one myth, Western Union clearly was not hoodwinked, for four days after the settlement, National Bell’s shares were sold at $955.50—an increase of $505 above the September market price. It strains credulity to suppose that Western Union’s management was not privy to the clear sentiment of the investment community. Bell had won a victory and Western Union knew it. The evidence indicates that Western Union settled for several reasons. First, financier Jay Gould had organized a new telegraph rival in May 1879 with a capitalization of $10 million. Moreover, Gould threatened an alliance with the Bell interests and promised to bankroll the infringement suit. Rather than fight on two fronts, according to this view, Western Union made peace on the telephone front in order to wage war more effectively on the telegraph front.

However, this two-front factor cannot alone explain Western Union’s behavior. The telephone’s commercial importance at the time was trivial in comparison to the telegraph’s. Western Union’s contest with the Bell interests was more a skirmish than a battle. Western Union could have fought on relatively cheaply if it believed that it could have won the patent battle in the courts. But Western Union agreed to a settlement precisely because its attorneys and other officials became convinced that the Bell interests would fight and ultimately prevail. George Gifford, Western Union’s lawyer, became convinced that Alexander Graham Bell had invented the telephone and that Western Union was an infringer. Accordingly, he urged his client to settle.³

The patent wars and the Western Union competition would impress Bell interests in an important way. Patents would become a critical component of telecommunications and, with it, research. The basic transmitter and the basic receiver were only the beginning. When the fundamental patents expired in 1893 and 1894, the Bell interests sought to be well ahead of their adversaries, which entailed obtaining more advanced patents either through internal development or from independent inventors. The latter alternative was at first more desirable when individual inventors working in their own shops could make continuous and significant contributions to telephonic advance. But when telephonic research became sufficiently complex to require large capital investment, substantial group effort, and advanced mathematical techniques, a major research laboratory was required. In this sense the patent battles and the Western Union competition ultimately led to the creation of that extraordinary facility, Bell Telephone Laboratories (Bell Labs).

The Business of Communications

Early telephone service and equipment were rudimentary by contemporary standards. Yet even in its earliest phases the Bell interests were compelled to devise policies based on the peculiar characteristics of telephone communication. The single most important characteristic is the interactivity of the network; that is, a weakness in any part of the system reduces the ability of the other parts to operate to full potential. A bad transmitter, for example, will be reflected in inferior sound flowing to the receiver. Early on, the Bell policymakers realized that weaknesses in any part of the system can retard the expansion of the network, lower its quality, or otherwise impede its more widespread acceptance and use, with a resulting negative impact on revenues. For this reason, the Bell policymakers sought control over each piece of equipment and service that the network comprised. This, in turn, raised the issue of whether such control should be exercised under a system of ownership or under a system of licensing according to standards set by Bell. Since licensing entails a considerably smaller capital outlay, it is not surprising that the Bell interests first chose that path so that the system would grow much more rapidly, since others would incur the costs for local systems, equipment supply, and so forth.

Another peculiar characteristic of the telephone business that the Bell policymakers came to understand was that the value of telephone service to any subscriber depends on the number of persons with whom’ he or she can communicate. The greater the number is, the more valuable the service is. This consideration compelled the Bell policymakers to focus attention to switching. Without a central switch, forty-five lines are needed to connect ten nodes, whereas with one central switch, only ten lines are required. Gradually the idea of a network evolved, consisting of switching centers distant from each other but connected by trunk lines, and hierarchies of switches. As the network grew, the company was impelled to invest resources not only in the engineering problems but in basic research as well. For in many cases the basic science and mathematics upon which the complex switching would be based was yet to be discovered.

When one combines the interactivity of the network with the ever increasing complexity that results from expanding it, the theoretical justification for direct ownership of each part of an integrated network—local loops, long distance, CPE (customer premises equipment), and switching and transmission gear—is clear. Economic and technological considerations led to the integration of research, planning, engineering, design, manufacturing, and operating capability within one firm. Thus the theory of the firm discussed in Chapter 1 shows why the Bell interests organized much of their activity internally rather than through the market employing the price mechanism.⁴

The Bell system followed this dynamic. The more complex and changing a product or service is, the greater the costs incurred in instructing others who are responsible for component parts; the less the tolerance for deviation, the larger the costs will be for the failure to fulfill one’s part in an overall interactive system. When complementarity is critical, yet at the same time the component sectors of an industry progress at uneven rates, the costs of discoordination can be very high. If licensees or independent sellers would have an incentive not to cooperate with the Bell interests in implementing or developing a new technology quickly or meeting a Bell target or rising standard of service, the effects would be felt throughout the network, and would be costly. The transaction costs in telephony are very high, so negotiation and changes and discussions of scientific and technological matters are more common than in many other industries. To the Bell interests transaction costs would be reduced if a single firm had the authority to enforce its will upon all segments of an industry.

Of course, it does not follow that only a single firm monopolizing all parts of the system was possible. But it does follow that a dominant, vertically integrated firm that could enforce its will on reluctant independents—the network manager role that AT&T undertook—was the direction in which telephone technology impelled the Bell interests, sometimes against their will.

The Foundations of AT&T

The predivestiture structure that we knew as AT&T, a holding company embracing operating companies and divisions in all phases of the telephone business, came into existence at the end of December 1899. Although much has changed over the years, it is remarkable how many AT&T policies in effect at the 1984 breakup (such as the one that insisted on leasing and not selling telephones) were in place on New Year’s Day, 1900. AT&T, which had existed as a long-distance company since 1885, took over the property of the American Bell Telephone Company, its parent, and from that point until January 1, 1984, performed several functions in the Bell system.

First, AT&T operated the Bell system’s long-distance service through the Long Lines Department. Second, it operated as a high command, making decisions for and coordinating the system as a whole. Third, it owned Controlling shares in Western Electric, its principal supply and manufacturing company, and in the local operating companies. Over the years AT&T’s shares in operating companies tended to increase. For example, AT&T had acquired 50.1 percent of Pacific Telephone and Telegraph’s shares by 1905. By 1980 the figure had jumped to 90.18 percent. In two cases—Southern New England Telephone (SNET) and Cincinnati Bell—AT&T always owned less than 30 percent of the shares. AT&T’s shares in these two firms were not affected by the divestiture, but they were sold nonetheless.

Bell Telephone Laboratories (Bell Labs), the last important component of the basic predivestiture structure, was incorporated in 1924. Almost at the outset it became one of the preeminent research organizations in the world. It was jointly owned by Western Electric and AT&T and was formed in order to better coordinate research and development, which had previously been undertaken by Western Electric Research Laboratories and various AT&T research and engineering departments. It is not uncommon for large corporations to have sizable research departments, but such research is almost always of an applied nature. In contrast, Bell Labs made enormous contributions not only in applied research but in pure science and mathematics as well. In large part the Bell system’s early commitment to science and technology stemmed from the fact that many of Bell’s technical problems could not be solved before advances were made in these fields.⁵

The complex structure of the Bell system evolved gradually from the invention of the telephone. Not until July 9, 1877, did the three original partners supersede their original partnership agreement when they formed a Massachusetts trust (a business form then popular) entitled the “Bell Telephone Company, Gardiner G. Hubbard, trustee.” By February 1878 the time had come to finance expansion of the business. Accordingly, the next stage was the New England Telephone Company, capitalized at $200,000. This company, which was restricted to New England, appointed agents to develop exclusive territories and compensated them with commissions on telephone and call bell (ringer) rentals. The markets opened up by the development of switching and other new services, the fight with Western Union, and other factors continued to impose an enormous financial burden on the Bell interests that the New England Telephone Company structure only partly alleviated. Accordingly, Hubbard and Sanders incorporated the Bell Telephone Company (a corporation, not a Massachusetts trust) in July 1878. But as they sought and obtained new investors, Sanders and Hubbard saw control begin to slip away. The new company, capitalized at $450,000, attracted as general manager Theodore J. Vail, a man who combined exceptional managerial abilities and a keen political sense. Vail had established a system of fast mail delivery for the Post Office. Beginning as a lowly mail clerk for the Union Pacific Railroad, Vail’s ability and energy in transportation services led to a meteoric rise. At the age of thirty in 1876, he was appointed general superintendent of the Railway Mail Service. Dissatisfied with economizing measures by Congress, he joined the Bell interests with the promise of the New York City franchise.⁶

Few large institutions have ever borne the imprint of one person as thoroughly as Vail’s on AT&T and its predecessors. He settled the Western Union suit and assertively moved to enlarge the use of the telephone. Among his first moves were expansion of the central switchboard exchanges, telephone fire alarm systems, and long distance (or toll lines), which, though modest by contemporary standards, were pathbreaking at the time. These ambitious projects led to further financial strain and the creation of a new company in March 1879, the National Bell Telephone Company, capitalized at $850,000. At this point the original partners were no longer able to control the fortunes of the telephone. After the Western Union settlement, under which the Bell telephone interests were required to purchase Western Union and American Speaking Telephone’s equipment, the need for additional capital led to still another transformation. The American Bell Telephone Company was incorporated on April 17, 1880, and capitalized at $7,350,000.

AT&T owes its creation to Vail’s dream of long distance. Even though the technology was incapable of carrying conversations very far in the 1880s, Vail was committed to the promise of allowing every subscriber to converse with every other one. Because American Bell met with little success in interesting its local licensees to jointly engage in long distance to and from their territories, it incorporated American Telephone & Telegraph (AT&T) as a long-distance subsidiary in February 1885. Interestingly, the certificate of incorporation contemplated a network that would extend throughout the United States, Canada, and Mexico. Under Vail’s leadership, by 1888 the new company was already confident that long distance would be a success.⁷

Ambitious plans entail substantial risks. Typical of such large-scale projects undertaken for the first time, the costs of creating a long-distance network were greater than initially seen. In 1888 AT&T was compelled to float a $2 million debenture issue to finance long-distance expansion. This bond issue and later public stock and bond offerings—a common feature in AT&T history—have acted as long-term incentives for the firm to be efficient in its operations. In its frequent resort to capital markets, especially in its sales of debentures, notes, and bonds, AT&T has had to appeal not to potential customers of its telephones but to investors who are ordinarily indifferent to the product or service in which they are investing. To them, return matters. Investors focus on risk, yield, and other financial variables. Any company seeking to sell debt instruments or stock in financial markets is reasonably expected to know that it must deal with sophisticated investors who will compare the seller’s performance (and probable performance) to those of other such firms, including those in highly competitive industries. If a company such as AT&T wishes, then, to sell stocks and bonds on favorable terms, its performance and probable performance must measure up to that of its rivals in competitive industries. The discipline imposed by the financial markets acts upon the firm as a surrogate for competition. Of course, this does not necessarily guarantee that such a firm will be efficient any more than competition necessarily assures that a firm will be efficient. But in both cases a strong incentive to be efficient is provided. Thus, the commitment that AT&T made to long distance had important consequences for the firm’s efficiency.

The Bell interests’ spur toward increased capitalization met with resistance by the Massachusetts legislature, which led the leaders of AT&T and American Bell to reach an important decision in 1899. In contrast to Massachusetts, New York, where AT&T was incorporated, was far more generous on the issue of increasing corporate capitalization. For that reason in late December 1899 AT&T became the parent company and corporate headquarters were moved from Boston to New York.

When 1900 dawned, AT&T was on its way to forming a comprehensive vertical structure. Western Electric, already an electrical equipment manufacturer, had been acquired in a gradual process that began on July 5, 1881. The need to keep up with an expanding demand for telephone equipment coupled with dissatisfaction with prior arrangements because of delays, shortfalls, imprecision, and so on led to the decision to begin the acquisition process of a major manufacturing facility. Hence, the Western Electric acquisition was a specific example of the empirical findings of economic historians Harold Livesay and Patrick Porter. Firms engage in backward vertical mergers “by a desire to rationalize flows by … assuring needed raw materials rather than from a desire to add profits of the manufacturer to that of those downstream in the business.”⁸

Similar rational considerations governed the license relationship for local operating companies. After a number of experiments that proved unsatisfactory, American Bell in the early 1880s solved the problem of how best to exploit local markets. It would offer licensees permanent licenses in exchange for stock, thus becoming a partner in the local-loop business. This allowed American Bell to conserve capital for long distance and other phases of the telephone business and at the same time maintain considerable influence so as to assure that licensees took a long-run view of the business. Thus, American Bell assumed, even at this early stage, the role of network manager that would guarantee the overall performance of an interactive system. It could further assure that as new technological innovations came about the licensees would not resist deploying them.

Gradually the local licensees consolidated into larger territories for several reasons, including economies in centralized management, lower transaction costs in larger exchanges, the high capital costs of some newer technologies, and increased coordination requirements. The final step was AT&T’s increased equity holdings in most licensees, which was more than 90 percent by the mid-1930s. The causes were the profitability of local-loop operations and AT&T’s dissatisfaction with minority ownership. AT&T officials had found that some of their licensees were not cooperating in the development of long distance and were resisting closer uniformity in good telephone practice. Moreover, under the system of minority share ownership some local managers were performing inadequately, impelling AT&T to incur higher supervision costs than would be the case with majority control. Consequently, AT&T purchased licensees’ stocks whenever it could.⁹

The basic predivestiture structure of AT&T was thus complete. As this review shows, sound business reasons existed for the integration of each component into the Bell system that died on the last day of 1983. As we shall see, sound reasons also existed for AT&T’s dominant status as regulated network manager and the structure of local and long-distance monopolies.

Regulated Monopoly and Public Service

At 7 A.M. on September 17, 1945, the fuses in the offices of the Keystone Telephone Company were pulled, marking the close of the second era of competitive telephony. Forty years earlier, the Bell system faced competition in many local markets and long distance. AT&T’s ability to survive the competitive onslaught as well as attacks by prominent legislators and the Justice Department is another tribute to Theodore J. Vail’s genius. For, at a critical time in the company’s history, he recognized the benefits of close public utility regulation through regulatory commissions, in exchange for which AT&T and its licensees obligated themselves to attain such goals as universal service and technological progressiveness. AT&T, in a word, had a private agenda wrapped in a public philosophy. It sought to show that its private interest was identical with the public interest.

The second competitive era began inauspiciously for AT&T. Anti-monopoly sentiment was rampant in the 1890s, and telephone competition was expected to lower prices and spur progressiveness. Yet by 1920 the belief in competition as the best public policy in telephony was dead; nor was it revived until the late 1960s. The overwhelming sentiment that competition was not the answer in telephony is summarized in a 1919 Missouri Public Service Commission report: “Competition between public service corporations was in vogue for many years as the proper method of securing the best results for the public…. The consensus of modem opinion, however, is that competition has failed to bring the result desired.”¹⁰

The principal reason that telephone competition fell into disfavor was AT&T’s advocacy of a public philosophy that persuaded virtually every important actor—eventually even its rivals—that the public interest would be best served under a regime in which public service commissions regulated telephone monopolies. American Bell (and AT&T) did not come to this position all at once but, rather, gradually and, once again, under the leadership of Vail. After the basic patents expired in 1893 and 1894, AT&T first sought to buy up sufficient patents to keep ahead of rivals. Because of adverse court decisions, that strategy failed. Competition began to develop gradually, and by about 1900 and for a few years thereafter more than five hundred independent telephone companies were established annually. Moreover, AT&T was singularly unsuccessful in preventing municipalities from granting franchises to rivals.¹¹ At the same time that competition provided a threat, so did nationalization. Manitoba in 1907 and England in 1911 had nationalized most of their respective telephone services.

After the turn of the century, progressivism, one of the tenets of which was firm government control of large business enterprise, had become the dominant public philosophy. One of the critical moves that AT&T undertook, especially after Vail’s return to the company in 1907, was to seize upon progressive sentiment and turn it to the Bell system’s advantage. To do this AT&T first embraced the theory of natural monopoly that had become fashionable in academic circles at the turn of the century. Although today an industry is considered a natural monopoly if production is done most efficiently by a single firm as output increases, the term had a somewhat different meaning in the Progressive Era. Based on the wave of bankruptcies and deteriorated service that had occurred in the traditional public service industries when multiple franchises were granted, the earlier view held that service to the public is best undertaken by a single franchisee or a “natural monopoly.” It is important to note the distinction between that conception and the later economic one. Better and more comprehensive service based on empirical observation is different from a theoretical conception that purports to predict what is most efficient. AT&T sought to clothe itself in the older natural-monopoly conception, the better to portray itself as the bearer of the public interest.

When Vail rejoined AT&T as president in 1907, he realized that one of his most important tasks was the elaboration of how an AT&T-dominated telecommunications industry would best accord with progressivism. Prior to his return the AT&T leadership was split about what its best strategy should be. Annual reports, therefore, avoided the important issue of the company’s attitude toward close regulation. In the 1907 Annual Report, the first written since Vail’s return, the company spelled out a refined theory of regulation that delineated the proper roles of private company and governmental supervisor: “It is not believed that there is any objection to [public control] provided it is independent, intelligent, considerate, thorough and just, recognizing, as does the Interstate Commerce Commission & that capital is entitled to fair return and good management or enterprise to its reward.”¹²

The 1910 Annual Report even more enthusiastically endorsed public regulation, adding that it should assure that plant and services is of the highest possible standard, efficient, and that service should be extended as far as possible—the universal service standard. Telephone companies are public service institutions and should be compelled by regulators to attain such standards. But regulators should stop short of attempting to manage the business. The following is the critical argument Vail made in favor of monopoly:

If there is to be State control and regulation, there should also be State protection—protection to a corporation striving to serve the whole community (some part of whose service must necessarily be unprofitable) from aggressive competition which covers only that part which is profitable. & That competition should be suppressed which arises out of the promotion of unnecessary duplication, which gives no additional facilities or service. & State control and regulation, to be effective at all, should be of such a character that the results from the operation of any one enterprise would not warrant the expenditure or investment necessary for mere duplication and straight competition. & Two local telephone exchanges in the same community are regarded as competing exchanges, and the public tolerates this dual service only in the fast disappearing idea that through competition in the telephone service, some benefit may be obtained&. Two exchange systems in the same place offering identically the same list of subscribers & are as useless as a duplicate system of highways or streets not connecting with each other.¹³

The 1910 Annual Report then established the quid pro quo that would replace competition. AT&T and its affiliates would willingly submit to commission regulation that would be committed to guaranteeing an efficient and progressive telephone service. Further, the commissions would be expected to prod the telephone system to attain high standards and expand the system. AT&T committed itself to be a network manager of the Bell operating companies and noncompeting independents. AT&T rejected, however, interconnection with independent companies that competed with either a Bell licensee or an affiliated independent on the ground that such interconnection was redundant. AT&T promised to unremittingly improve equipment and operating procedures and to continue expansion into uneconomic, sparsely settled and difficult-to-reach territories. Most importantly, AT&T committed itself to ultimately attain universal service so that virtually everyone who desired a telephone could have one and could communicate with everyone else. Obviously, the public utility commissions (PUCs) would be expected to regulate telephone pricing so that the subsidy flows would allow these goals to be achieved.

It should be noted too that Vail held out the olive branch to independents—a shrewd political strategy. AT&T did not advocate that it become the sole provider of telephone service but rather the network manager of a vast network that included Bell companies, Bell licensees, and noncompeting independents. Politically this was important because independents often had strong ties to local elites. Merchants and other businesses increasingly relying on the telephone approved the regulatory commission idea that promised stable and reasonable rates as well as a high grade of service. They usually disapproved of competing service because nonconnecting systems prevented them from communicating with some suppliers and customers.¹⁴ Thus, those independents who favored competition and rejected the independent regulatory commission idea were increasingly isolated both politically and in terms of the goal of attaining a vast network in which any person could converse with any other.

Notwithstanding some conduct that was sharply criticized, a major antitrust investigation, as well as the threat of nationalization, AT&T had successfully wrapped itself in the mantle of the dominant public philosophy when Vail retired in 1919. By the early 1920s AT&T and the surviving independents were close allies.

The Public-Private Partnership

At the end of 1920 all but three of the forty-eight states had PUCs with the power to regulate telephones. Since most telephone matters concerned local rates or local service, the PUCs were the core of the system of regulation. Notwithstanding the differing public philosophies that prevailed in the 1920s and 1930s, the idea that privately owned firms in public utility industries should be closely regulated was widely accepted.

At the federal level telephones first became subject to rate regulation (by the Interstate Commerce Commission) under the 1910 Mann-Elkins Act. Under an agreement (known as the Kingsbury Commitment) into which the Justice Department and AT&T entered in 1913, the company agreed not to acquire any competitors and to furnish interconnection to noncompeting independents into the Bell network. And in 1921 Congress enacted the Willis-Graham Act, extending ICC jurisdiction over telephone mergers and acquisitions, thereby effectively abrogating the portion of the Kingsbury Commitment prohibiting AT&T acquisitions. By this time earlier controversies had subsided and every major actor had come to agree with Vail’s 1908 formulation: “One policy, one System, Universal Service.”

In the thirteen years between Willis-Graham’s enactment and creation of the Federal Communications Commission in 1934, the ICC considered at least 274 merger and acquisition cases, certifying 271. State PUCs that could regulate telephone mergers generally approved them, as well. The ICC’s activities served to rationalize the industry. The leading study of ICC telephone regulation concluded that acquisitions usually occurred “because the smaller system lacked capital, credit and revenues to extend or even maintain its plant or because the owners of the small enterprise desire to withdraw from the telephone business.”¹⁵

Although the F.C.C. supplanted the ICC in 1934 and gained greater powers, it is nevertheless true that until the major changes that began after World War II, the bulk of regulation occurred at the state PUC level, and the regulatory system worked well. Even a cursory look at the American telephone industry from 1920 to 1968 shows its remarkable progress under the regulated network manager system. Telephone company profits were reasonable and far from monopoly levels in large part because they were rigorously controlled by public utility regulators. Of course, trends in communications, like trends in other sectors, are dependent in no small degree on general economic trends. Thus, a downturn during parts of the Great Depression as well as substantial growth during the boom that followed World War II are to be expected. Nevertheless, while GNP increased approximately fivefold between 1920 and 1970 (from about $140 billion to approximately $722 billion, in 1958 dollars), telephones increased almost ninefold (from 13 million to 120 million) during the same time period. Even more remarkable, while 35 percent of households had telephones in 1920, the comparable percentage in the larger 1970 population was 90.5 percent. And, of course, since interconnection of telephones was virtually completed by 1970, the value of the telephone to each subscriber was incomparably greater in 1970 than in 1920.

These considerations do not begin to exhaust the long-run achievements of the regulated network manager system. The telephone in America had achieved the status of a necessity for both business and residential users; the structures of commerce, entertainment (through radio and television), and social intercourse became completely dependent on the telephone system. Americans needed to work fewer hours per year to obtain telephone service than residents of other developed nations. A 1971 Department of Commerce study, for example, showed that the average American needed to work twenty-six hours per year to obtain basic telephone service, whereas the average French citizen required 179 hours. The number of Americans on waiting lists to obtain telephone service was lower than that of any other country with a large system. Finally, we must consider the extraordinary research and development record of Bell Labs, the benefits from which have extended far beyond telecommunications.¹⁶

PUCs have often been attacked. They have been charged with corruption, incompetence, or simply disregard for the public. But considering the large number of cases that they have handled, there have been very few cases of proved corruption or blatant disregard for the laws they are charged with enforcing. PUC critics usually are satisfied with naked allegations of the agencies being “captured” by the regulated firms. And, of course, some demagogues, claiming to represent “the consumers’ interest,” oppose all rate increases. But these sweeping claims are nothing more, as R.H. Coase has said, than presumptions of what the consumer interest should be.¹⁷

The PUCs are compelled to exercise continual—long-term and short-term—authority over the industries they regulate. They must consider both the consumers’ interests and the producers’ interests, for unless the producer can make a reasonable profit and attract capital for expansion, the consumer cannot be effectively served. PUCs cannot avoid blame for performance deficiencies; they cannot even blame the regulated companies for deficiencies because their own lack of foresight or inadequate supervision of the industry is viewed as the primary source of failure. In short, PUCs should be obligation oriented and collaborative with regulated firms. Although collaboration is inconsistent with a strictly adversarial attitude, it is not inconsistent with one in which the PUC does not act on or grant a company’s request unless the company’s showing is clear and convincing.

What compels PUCs to behave in this fashion? PUCs are constrained in many ways. Courts, the executive branch, and legislatures exercise considerable supervision—and, more importantly, power—over PUCs through hearings, legislation, appropriations, oversight, and enforcement. Information about alleged transgressions on the part of PUCs or the firms they regulate is readily available from a variety of sources, many of which have strong incentives to exercise considerable scrutiny. There are many eyes on the results of PUC regulation as well as on the ways in which the results are achieved. All decisions, including regulatory ones, allocate resources so that there are winners and losers. For example, if our utility rates increase and our service does not improve, we know it; if we experience a brownout, we know it. Criticism of this kind is often used by political actors willing to exploit it as an issue. In addition, others are deeply involved in most regulatory decisions, either as close watchers or as participants. Interests concerned about PUC telephone proceedings include (1) residential subscribers, (2) consumer organizations, (3) business users, (4) trade associations, (5) equipment suppliers and potential suppliers, (6) competing carriers, (7) large telephone companies, (8) independent telephone companies, (9) rural cooperative telephone companies, (10) telephone company trade associations, (11) companies involved in other markets or technologies on which PUC decisions may impinge, and (12) government purchasers of telecommunications services, such as the Department of Defense.

This, of course, does not suggest that all of these economic interests are represented in every proceeding. Rather, they do hire lawyers and lobbyists to scrutinize what PUCs and the F.C.C. are doing or plan to do, so that any economic interest that may be affected by a proceeding usually has the opportunity to intervene. Further, a variety of governmental institutions claim to represent not their own interests but the public interest, often with varying and divergent views of what constitutes the public interest. These “guardians” of the public interest include (1) other state PUCs, (2) NARUC (the association of regulatory commissioners whose predecessor dates from 1889), (3) local governments, (4) other state and local government agencies, (5) state attorneys general, (6) local prosecutors, (7) the Justice Department, (8) the Department of Commerce and various divisions of it concerned with telecommunications, (9) the Office of Management and Budget and parallel state agencies, (10) various watchdog agencies (such as the General Accounting Office and its state parallels), (11) legislators who are attentive to public utility and telecommunications issues, (12) legislative committees, (13) other agencies (such as agriculture departments in rural telecommunications matters and the Department of State in international matters), and, of course, (14) the courts. Always present, too, is the threat of a special committee appointed to examine the performance of PUCs or regulatory agencies in general. Finally, there have been numerous instances of agency staff, concluding that a PUC has taken a wrong turn, leaking information to the media, legislators, and others.

There are also many private guardians of the public interest. Muckrakers such as Ralph Nader have existed even before public utility commissions. Although these would-be guardians of the public interest are often biased or simplistic or have failed to investigate an issue reasonably well, they do serve a useful purpose. The threat of investigation provides regulators with an added incentive to defend their actions and to show that the alternatives were less attractive. These “political entrepreneurs,” as James Q. Wilson calls them, are adept at mobilizing latent public sentiment by revealing a scandal or capitalizing on a crisis.¹⁸ In their endeavors, the private guardians of the public interest are often surreptitiously aided in obtaining information from PUC insiders. They are also adept at leaking what they have learned to sympathetic media reporters.

Legislative appropriations and oversight hearings, executive-branch reviews, adverse publicity, the threat of forced resignations, and even criminal prosecution provide PUCs strong supplementary incentives to follow paths dictated by statutory goals. PUCs do make mistakes and can differ among themselves, but, like courts, they establish principles that are developed over the years and that are based on experience, daily contact with concerned actors, and continuous supervision of regulated firms. Decisions are articulated in written opinions based on facts and reasoned to conclusions that regulators hope will withstand the scrutiny of courts, legislators, executive-branch officials, and the attentive public. And, they have usually withstood this scrutiny.

By 1920 PUCs concluded, in the words of the California agency: “After a number of years of experience with two telephone systems in these communities, the subscribers almost unanimously demand a consolidation into one system.”¹⁹ Thus, the PUCs had accepted as the public interest the basic vision outlined by Vail. That is, in exchange for monopoly privileges, telephone companies became stewards charged with rendering cheap, efficient service of high and improving quality. Telephone companies were held to the standard of end-to-end responsibility in which they were continuously charged with maintaining the quality, safety, and effectiveness of each component of the network. Since the telephone companies were charged with end-to-end responsibility and the network’s overall quality was adversely affected by the quality of the worst component of the system, PUCs required telephone companies to lease equipment. If subscribers supplied their own equipment, according to PUCs, quality could not be assured.²⁰ Finally, PUCs devised many quantitative standards governing such things as switchboard capacity, promptness in handling calls, and conversion time to higher levels of service.

Ultimately, the regulated network manager system must be judged by performance criteria. Did the system work? In general we can say that the system worked well, and although there were some rough spots and downturns, it improved in the long run. Consider one example: Before World War II, the time required to establish a long-distance telephone call was approximately three minutes; in the 1960s, it was one and one-half minutes; and by 1973, it was further reduced to under forty seconds. The same progress applies to other measures of telephone company performance as well, all of which occurred under conditions of reasonable, and often declining, rates. According to the Department of Labor, the Bell system’s productivity gains between 1972 and 1977 exceeded those of all but one of the sixty-three industries that reported such data. Moreover, fifty-one of these industries had labor productivity growth less than one-half of the Bell system’s. In the overall inflationary period from 1947 to 1977, the telephone industry’s rate of price increase was about one-half that of all industries combined. Between 1960 and 1973, the consumer price index (CPI) increased 44.4 percentage points, but the residential telephone component increased only 14.6 percentage points. Further, during the highly inflationary period of 1973 to 1979, the CPI increased 84.3 percentage points and the telephone component only 16 percentage points. Between 1965 and 1977 more than 240 of the 264 items in the CPI showed rates of price increases greater than telephone rate increases.

Both the postwar and prewar record, we should recall, occurred as AT&T continuously engaged in extensive research and development to assure progressiveness and the attainment of universal service. And this occurred when rates were made in such a way that Bell profits were always reasonable.²¹

The First Boundary Problem: Radio and Telephones

We noted in Chapter 1 that political disputes in telecommunications frequently arise in connection with boundary problems when entrepreneurs see the commercial opportunities for a new technology. When the older and newer technologies may compete for the same markets, a clash is almost inevitable. If the older technology is a heavily regulated one, the crucial issues include what kind of public policy regime should govern the new technology—competition or public utility status, or some mix of both. A second set of issues concerns whether firms in the older industry should be allowed to enter the new one, and whether firms in the newer one should be allowed to compete with those in the older, heavily regulated one.

Even as AT&T and the telephone independents were settling their controversies, a new one based on the boundary problem and AT&T’s technological prowess was brewing. The radio controversy unleashed considerable resentment against AT&T that would carry over into the anti-big-business 1930s. The Bell system’s successes in developing other novel technologies, such as television and sound motion pictures, would contribute importantly to an extremely hostile F.C.C. investigation in the 1930s and to the 1949 antitrust suit against the company.

When World War I ended few people saw that the most dramatic application of radio would be in broadcasting, not point-to-point communication. AT&T envisoned radio’s potential in extending long-distance telephony. Accordingly, it invested its efforts in radio development and acquired patents of others. Its overall attitude before the radio boom was that radio telephony could never replace wire service but could be a valuable supplement to reach relatively inaccessible places.²²

Unregulated firms such as General Electric, Westinghouse, and United Fruit became involved in radio research for their own reasons. General Electric and AT&T contested twenty radio-related patent interferences between 1912 and 1926, and each firm could block the exploitation of the other’s patents. That is, each could not effectively use its patents without infringing upon patents held by another firm. Because these events occurred in the period around World War I, the United States government (principally through the Navy’s Bureau of Steam Engineering) sought to resolve the patent tangle and, at the same time, assure that control of the new technology and its development was in American hands. The net result was the formation in 1919 of the Radio Corporation of America (RCA), closely linked with General Electric, and the creation in 1920 of a patent pool embracing General Electric, AT&T, and other firms that allocated exclusive and nonexclusive fields in virtually every phase of communications, including broadcasting.²³

Even though the patent pool agreements were carefully crafted, bitter disputes between AT&T and a coalition led by General Electric erupted, largely because of ambiguities in the clauses concerning broadcasting. At the time the agreements were signed none of the parties foresaw how rapidly the broadcasting boom would occur. Although they envisioned many uses for radio, they did not anticipate its importance as a medium of entertainment and information. The broadcasting boom began in 1920, a few months after the patent pool was formed. When Westinghouse erected a powerful transmitter in the Pittsburgh area and developed a regular schedule for the station to broadcast nightly, AT&T and the other members of the patent pool then appreciated the lucrative opportunities in the new field of broadcasting. By 1925-only five years after Westinghouse’s KDKA had begun—2,750,000 households had radio sets. And this figure barely touched the vast market of families that would want radios.

The inevitable disputes were fought not only in the realm of interpreting the patent pool agreements, but in the political area of defining the public interest in broadcasting as well. AT&T sought to include broadcasting on its side of the boundary through a concept it called “toll broadcasting.” On January 6, 1922, AT&T issued a public announcement stating that it would operate a radio station. AT&T “will provide no program of its own, but provide the channels through which anyone with whom it makes a contract can send out their own programs. Just as the company leases its long distance wire facilities for the use of newspapers, banks and other concerns so it will lease its radio telephone facilities and will not provide the matter which is sent out from this station.”²⁴

AT&T, in a word, had devised a plan in which there would be a complete divorce between the production of programs and their distribution to the public. Unlike the system that prevails today in which the networks and cable companies determine which programs will be distributed, the toll broadcasting idea envisioned the distributor as nothing more than the conveyor of material over which it had no control. Just as the telephone company has no control over the conversations of its subscribers, radio transmitting companies would simply sell blocks of time to programmers.

But AT&T’s attempt to employ public service principles in broadcasting soon collapsed. Although toll broadcasting does not necessarily imply monopoly in distributing programming, AT&T was attacked on the ground that it was seeking to extend its telephone monopoly. Further, the decision of the arbitrator appointed to decide whether AT&T could enter broadcasting under the patent pool agreement was adverse to the telephone company’s position. The effort of RCA and its allies to exclude AT&T from broadcasting was reinforced by AT&T’s assertion of its patent rights against radio stations infringing on its broadcasting transmitter patents. Even though AT&T was legally entitled to protect these patents, the adverse publicity reinforced the public fear that the company was attempting to enlarge its monopoly. Legislative and executive attacks on the telephone “monopoly” intensified, and at the same time some government officials expressed displeasure over certain news commentary on an AT&T station. All of these factors led to AT&T’s withdrawal from broadcasting in 1926 and its decision to sell its existing stations to RCA. The toll broadcasting experiment ended, demonstrating how difficult it would be to embrace novel technologies within the public service ambit.

The Creation of the Federal Communications Commission

At the most obvious level, the F.C.C. was created in 1934 to combine the radio regulatory functions of the Federal Radio Commission (FRC—created in 1927 to grant, renew, or revoke station licenses) and the telephone regulatory functions of the ICC into a unified agency.²⁵ AT&T had opposed the creation of a unified agency when it was first proposed in 1929, but with the advent of the New Deal in 1933 and the climate of anti-big-business feelings focused on public utility holding companies, AT&T expressed even more apprehension. Even though the major governmental reports advocating the creation of a unified agency emphasized that significant changes in existing law would not take place, AT&T had reason to be apprehensive. The House Report envisioned a future report by the new agency on such topics as whether AT&T ought to be compelled to engage in competitive bidding for equipment instead of relying on Western Electric.

Nevertheless, the Communications Act of 1934 was intended to be largely a matter of administrative consolidation. But it was also expected to be the prelude to much more drastic regulation and legislation that would follow an F.C.C. investigation of telephone company practices. Certainly the New Deal’s first one hundred days justified AT&T’s apprehension, in which it was joined by the independent telephone companies. Among the statutes that then sailed through Congress were those that divorced commercial banking from investment banking; established federal control over new securities issues; and, most controversially, created the National Recovery Administration to establish federal supervision over virtually every facet of activity in almost every industry. From AT&T’s perspective the federal government had marched beyond the boundaries between private management and regulation under the old public philosophy and was on the road to establishing a new one in which government would dictate how a company ran its affairs on a daily basis.

The forces favoring the new agency, however, were successful precisely because they identified the public interest with administrative consolidation and a full-scale investigation. With these arguments the proponents of the new agency did not need to find particular examples of AT&T wrongdoing. Vague accusations and calls for an investigation were employed as secondary arguments. The forceful statement of ICC commissioner Joseph B. Eastman, the most highly respected regulator in the nation, that the ICC was doing a satisfactory job of telephone regulation, as well as declining interstate rates, were insufficient to overcome the chorus calling for a new agency. The new F.C.C. was created in 1934. The chain of events that eventually transformed American telecommunications can be traced to its origin.