9

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Telecommunications Turbulence

The Future as History

Telecommunications history has consisted of the interactions between government intervention, entrepreneurial and corporate innovation, and technological and scientific invention. This book has sought to trace the complex relationships among these factors, and to show that reductionist arguments purporting to explain the progress and development of the United States telecommunications system are misplaced. Certainly, as the experience of the communist countries has shown, publicly owned and operated enterprises have been found wanting. But there is surely enough experience to show that private ownership coupled with some degree of public involvement can yield good economic and social results. As the last chapter indicated, the Internet would probably not have been constructed without government and then university dominance. Yet in the most recent phase of the World Wide Web, government has quite properly retreated into the background.

No one would deny that private enterprise, relatively unhindered by public regulation, has contributed mightily to technological progress, but the view that state intervention can only impede the deployment of the technological fruits of private enterprise is grossly overstated. The close relationships between the state and private enterprise in Japan, in several Western European states, and most recently in such newly industrializing nations as South Korea have shown that government may play a positive role in technological advancement. Most of the recent complaints about government involvement have been concerned about its welfare role, broadly defined, not its role in technological advancement. The state can adopt a variety of postures toward new technologies extending from benign neglect to active participation, and the impact of public intervention can range from destructive to helpful. Each case must be considered separately.

American historical examples illustrate the diverse ways that government can act upon and affect technological and economic development. Consider first the American industry that is the envy of the rest of the world—agriculture. Not only is American agriculture extraordinarily technologically progressive and efficient, it has had a remarkable record in contracting the period between technological discoveries and their actual deployment. Wayne Rasmussen’s important study of agricultural innovation has shown that the exemplary record of American agriculture is directly related to the agricultural extension stations, land-grant colleges, and other programs fostered by the Department of Agriculture and such statutes as the post–Civil War Morrill Act.¹ Government intervention is most intense during periods of war, and it is precisely during such periods that government has accelerated the pace of technological deployment, as many examples in this book have shown.

Of course, government intervention does not necessarily lead to a more rapid deployment of new technologies than a free market would. Indeed, as Paul MacAvoy and James Sloss have shown, the deployment of the unit train (a train devoted to shipping only one commodity between two points) was adopted very slowly because the Interstate Commerce Commission instituted inconsistent and wrong-headed policies that discouraged the progressive new service. Again, a governmental authority can foster an inferior and unnecessarily costly technological option, as Congress did when it enacted a law forcing manufacturers of television sets sold in the United States to include UHF reception capacity.² Notwithstanding these cases of misguided government intervention at the administrative and legislative levels, one can point to many counterexamples of successful government intervention, as we have seen.

The relationship between government intervention, entrepreneurship, and technological innovation is a complex one. Shibboleths, like faith in free and open competition, are too simplistic and reductionist to enable us to understand the interface between government and the private sector in advancing new technologies. Nor, of course, is government intervention, no matter how it is applied, the only important variable in understanding the pace of new inventions, their importance, or the rate at which they are commercially deployed. One must concur in Jacob Schmookler’s conclusions that potential profits, the state of science and technology, risk of failure and the type of invention are among the crucial variables.³ Government policies (or nonpolicies) may be appropriate under one set of conditions but wrong in others. Telecommunications, during most of this century, was a homogeneous product—plain old telephone service—carried over a single kind of pipe—copper wires—in which the primary goal was to attain universal coverage as rapidly as feasible, because the positive externalities on business and residential subscribers would be very high. The solution, after the failure of a competitive interlude, was the AT&T-dominated regulated network manager system, involving substantial cross-subsidies from business to residential subscribers, urban to rural ones, and so on. Open interconnection of devices could impair the system and even be dangerous with few compensating benefits. The private firms were regulated by the F.C.C. and state commissions, which, overall, did their jobs well. The system worked. For example, in the period between 1972 and 1977, the Bell system’s labor productivity growth (closely related to the deployment of newer technologies) exceeded that of all industries but one (hosiery) that the Labor Department studied. Again, while the consumer price index between 1960 and 1973 increased by 44.4 percentage points, the residential telephone service component of the index increased by only 14.6 percentage points.⁴ Moreover, it is universally accepted that Bell Telephone Laboratories was one of the—if not the preeminent research institution—in the world.

Conditions began to change slowly in the 1960s. Hindsight is wonderful, but regulators unfortunately do not have crystal balls. Nevertheless, the agencies began to grope and feel their ways toward new policies that would respond to would-be entrepreneurs who wanted to challenge the Bell system with their new technologies, most importantly the computer. Quite significantly, as the unknowns multiplied, the agencies more and more moved in the direction of allowing markets to reach solutions. Markets can offer a variety of alternatives and let consumers decide on the basis of quality and price—a preferable solution when conditions are in flux and the future is unclear. Accordingly, AT&T was less and less able to protect its monopoly positions before the regulatory agencies as they moved toward adopting procompetition positions. If this sounds like a naïve argument that regulators seek to reach the best results that will advance the public interest, so be it. But there are sound reasons for holding that regulators are compelled to behave in just that way, as this book has attempted to show.

Our administrative system has to a considerable extent been patterned on our judicial system. That is, it is based on an adversary system (often involving many more than two sides) in which skilled advocates forcefully present the factual and legal arguments of their clients. Agencies cannot ignore such arguments and, indeed, are compelled to rationally explain what they reject. In contrast, legislators can babble away, act as demagogues, or ignore what is inconvenient. Agencies are also bound by most of the formal mechanisms concerning evidence, precedent, and so on that characterize the Anglo-American legal system. Consequently, an agency proceeding almost always contains: (1) the position and arguments advanced by the various sides to a controversy, (2) agency consideration of the arguments, and (3) a reasoned basis for the adoption of one policy rather than others. This is not to suggest that agencies are “above politics” or that there cannot be “hidden agendas.” Rather, they are severely constrained to make decisions on policy grounds. Notions that large corporate interests routinely “capture” agencies are belied by the facts and by the crucial importance of procedure in their proceedings. AT&T, for example, was routinely thwarted by the F.C.C. after 1968, losing important markets to much smaller competitors. And in cable television the F.C.C. began to render decisions favorable to the upstart cable industry and against the interests of the three giant over-the-air networks.

In the present era the imponderables in telecommunications have reached an unprecedented state. CPE now includes everything from computer workstations to traditional “dumb” telephones. The distribution systems include copper wire, coaxial cable, microwave, optical fiber, different kinds of satellites, and a wide variety of other wireless technologies. Transporters of information include local and long-distance companies, cable television firms, Internet providers, and a variety of other interests. Thanks to the digital revolution, computing and telecommunications architectures are more open than ever before. At the same time digital compression technologies have made it possible to transport data in smaller packages so that virtually any kind of medium can move any kind of information. And we are only at the beginning of compression technology (through encoding, reducing redundant information, and other techniques), the mirror effect of which is to greatly enlarge the transmission capacities of each telecommunications sector.⁵ The inevitable tendency of these trends is to converge markets. Information is information, and if there is sufficient capacity to carry it and there is a profit to be made, the type and content are unimportant. Of course, we should underestimate neither the technological and business difficulties in entering a new business nor the cumulative benefit of experience in each market. But these barriers can be overcome by entering into the right alliance. Congress, as we will see later in this chapter, recognizing the inexorable trend of market convergence, enacted the Telecommunications Act of 1996, the basic purpose of which was to open up each telecommunications sector to the competition of other sectors. Cable companies can enter local telephone markets and vice versa; local companies can enter into long distance and vice versa, and so on.

But who will the winners be? What technologies will prevail? In attempting not to guess incorrectly and to hedge their bets, firms have a strong incentive to enter into alliances with others emphasizing different technologies or operating in a different region of the country or a different part of the world. But will this inexorable incentive lead to the creation of a few colossal “telesauri”?

Telesaurus Rex?

In 1995 alone the telecommunications sector witnessed 126 deals, merging assets of $39.1 billion. Entertainment, media, computer software, and other sectors impinging on telecommunications also saw numerous combinations.⁶ Of course, many other sectors were involved in alliances, mergers, and acquisitions. Nevertheless, the turbulence in telecommunications requires investigation. And mergers and acquisitions were just part of the structural activity in telecommunications and its related sectors. There were joint ventures, divestments, the formation of new units, and so on. Consider just the major Internet-related activities that occurred in the first twenty-three days of the single month of January 1996: Sun Microsystems formed Java Soft to promote the Java programming language; Microsoft bought Vermeer Technologies, a Web page maker; Sears-Roebuck made clear that it was going to sell its interest in Prodigy; Netscape and Verifone announced a joint venture to develop software that would make it easier for banks and merchants to accept credit-card payments over the Internet; Sun Microsystems was engaged in (eventually unsuccessful) talks to take over Apple Computer; General Electric agreed to sell GEnie, its on-line service, to Yovelle Renaissance Corporation. And this occurred in only one sector of the vast number of activities embraced within modern hypercommunications.⁷

The Sun-Apple deal was never consummated. But from our perspective of understanding the nonstop turbulence, that is relatively unimportant; after all, you are still shopping for a new car even if you walk away from twenty dealerships. Consider the labyrinth of deals, some of which were successfully concluded while others were not, in which the RBOC spin-off companies were involved, even before the 1996 Nynex–Bell Atlantic and SBC–Pacific Telesis mergers, reducing the number of such companies to five. Nynex has made major telecommunications investments overseas, joined with Philips, the electronics giant, to develop voice and text information services for residential subscribers using visual display telephones, and invested $1.2 billion in Viacom, the huge entertainment and cable firm. SBC (formerly Southwestern Bell) acquired two cable systems in the Washington, D.C., area; together with Cox Communications (with which it had discussed a merger) it operates the fourth largest cable television system in the United Kingdom; and it purchased a substantial interest in Telmex, the Mexican telephone company. Bell Atlantic, in addition to its failed merger with Tele-Communications, Inc. (TCI), the largest cable television provider, and its successful one with Nynex, owns shares in telephone companies in New Zealand and Mexico and has worked with Oracle Systems, a leading maker of database management systems, to create an interactive shopping, entertainment, and information service.

One could go on and illustrate that every other player has engaged in a bewildering variety of ventures. The theme, however, is evident. Traditional telephone companies have sought international ventures and other opportunities outside the narrow range of plain old telephone service. A look at the failed Bell Atlantic-TCI merger can provide important data on the dynamics at work. The deal fell apart when Bell Atlantic rejected the $32 million price tag.⁸ International opportunities and perceived market convergence are among the principal factors that have driven most of the structural moves in telecommunications, including the Bell Atlantic-TCI one. Bell Atlantic chairman Raymond W. Smith, one of the most articulate telecommunications executives, clearly described the incentives on both sides of the proposed merger:

It also became clear that digital technology was causing a convergence of markets and industries…. “Convergence” means that the three principal consumer communications devices—computer, TV and telephone—are merging into one, and as they do, so too are the distinctions among once-separate businesses…. As the pace of change in our industry began to pick up, we started looking for the best way to put together all the capabilities we need—distribution, programming and packaging—in the shortest possible time.⁹

The media construed the attempted merger in much the same way. Business Week, for example, asserted, “With their deal, Bell Atlantic and TCI plan to bring their communications expertise to new markets—challenging local phone monopolies by providing video-on-demand, home shopping and even local phone service.”¹⁰ The San Jose Mercury-News, one of the leading sources of information on technology topics, summarized: “Bell Atlantic and TCI join a growing list of telecommunications and technology companies bent on being major players in building and operating the information highway. Early this year another huge phone company, U.S. West, bought a major stake in Time-Warner, the second largest cable operator in the country…. On Wednesday, BellSouth bought a 22.5 percent stake in Prime Management, a Texas-based cable operator.”¹¹ The article then pointed to the enormous hardware expenses, including fiber-optic cables, switches, computers, terminals in homes, and so on necessary to create the information superhighway—a colorful term that essentially means an expanded network that can carry every kind of information to every kind of terminal device—PC, television set, telephone, or some combination of all of these. The risks in guessing wrong on any component of the network, the Mercury-News added, are very high, as are the risks in failing to patch together the complex technologies required to transmit the different kinds of information on demand to a multitude of customers with varying requirements. Acting as a disincentive to market convergence is whether a sufficient number of people want everything from voice, video, and data to sophisticated interactive services, such as home shopping and videoconferencing, at the rates requisite to return a sufficient profit on the enormous investment required.

The Bell Atlantic—TCI merger failed; but many have succeeded, and the pace of intercorporate linkups remains dizzying. The lessons of the Bell Atlantic—TCI failed engagement are as valid as the deals that resulted in a marriage—or, at least, the partners living together in a less formal arrangement. The trend is clear and compels us to ask why.

We begin with Moore’s law, an observation first uttered by Intel cofounder Gordon Moore in 1964. The number of transistors on a given area of silicon had roughly doubled every year. The relation held until the late 1970s, at which time the doubling period slowed to eighteen months. These ratios have persisted at least until late 1995. While Moore has predicted that his law “will continue for a couple of more generations,” he concedes that “Beyond that things look difficult.”¹² Whether his prophecy will be right is almost beside the point. The microchip, whether in the form of microprocessor, microcontroller, DRAM chip, or whatever, is the fundamental technology that has moved telecommunications at its amazing pace. Chip advances not only determine the speed of devices and networks, but also lead to better performance, new applications, new devices, and “smarter” equipment. As hundreds of firms undertake the application tasks for new generations of chips, telecommunications company risks in guessing wrong on a new technology or holding on to one in danger of rapidly becoming obsolete are very high. For example, how can a firm heavily invested in fiber-optic transmission guard against the possibility that a new wireless technology (for example, CDMA, mentioned in Chapter 7) will make its current technology backward, or even obsolete?

The solution to the risk posed is hedging. Make bets on other existing technologies or new ones that may come on line. You can do this in one of three ways: (1) incurring the development costs, (2) purchasing a new technology after it comes on line, or (3) entering into an alliance or merger with another firm that has superior expertise in the new technological area. While all three options are possible, there are often significant shortcomings in the first and second. The first alternative does nothing to reduce risk, and can be very costly, and the possibility of failing to develop a technology new to the company’s scientists and engineers can be high. Second, while purchasing a new technology reduces development risks, it may not be available at the earlier marketing stages. This is a crucial drawback in telecommunications because of the lightning speed with which older technologies are upgraded and new ones introduced. In such a situation even a short delay in coming on line with a new technology can have a serious adverse effect on a company’s profits and, perhaps more importantly, its reputation for being a technological leader. There is no danger more serious in modern telecommunications than being viewed as a laggard. Accordingly, the third option is frequently the most attractive one. It can resolve the issues raised in the first two options, and while one must share the potential profits, risks are reduced. Sanjay Kumar, president of the software giant Computer Associates International, observed: “It’s much more acceptable for companies that have good technology to supplement their own products.” A managing director at the investment firm Lazard-Freres put the same thought in a different way: “Entrepreneurialism is giving way to basic economic trends of consolidation.”¹³ In summary, one can guard against imperfect knowledge about future trends in technology by engaging in mergers, joint ventures, and alliances.

There are other reasons driving the same trend. Some are, of course, financial. High-technology industries flourished in the stock market boom, and firms engaging in alliances and mergers frequently enjoyed an especially large spurt in stock values—to the delight of the executives involved. Second, vertical integration can, but does not necessarily, lead to economies of scope stemming from technological complementarity of the two or more firms, improved coordination of output through successive stages, and elimination of transaction costs (purchasing and selling). Third, a firm that does business in many geographical markets and has a variety of product offerings in the increasingly heterogeneous hypercommunications sector satisfies the desire of large buyers for one-stop shopping. This helps to drive combinations that enlarge both geographical markets and the diversity of product offerings.

Fourth, the promise of digital compression technologies effectively enlarges the transmission capacity of telecommunications carriers. In turn this provides a major incentive to utilize the enlarged capacity. One way of doing this is to transmit types of information that a firm traditionally has not carried. For cable systems this means carrying not only video information, but also data and voice telephone. It also provides an incentive to offer newer services such as interactive video and voice-over-data. But the problems that cable confronts to meet such challenges virtually call out for such firms to seek partners. Cable companies have traditionally been the technological laggards in the telecommunications area. Facing the daunting technological challenges as well as the detailed market information requisite to offering data, telephone, and advanced services virtually compels them to seek out loose-knit or tight-knit partnerships. Additionally, cable transmission has traditionally been a downstream business transmitting entertainment. The contemplated expansion of services requires solving the problems associated with moving information upstream to the cable system head-end and switching and interconnecting into other networks. Resolving these problems as well as expanding upstream bandwidth also provides incentives to undertake combination with firms in other telecommunications sectors. Similar technological and marketing problems also face telephone companies, Internet providers, and others who, therefore, also are provided with similar incentives, especially if they wish to provide entertainment over networks.¹⁴

Fifth, the concept of product differentiation provides still another reason for alliances. Product differentiation refers to the question of whether the products of competing sellers in a market are viewed as identical or different. What matters is consumers’ subjective judgments about quality, design, packaging, reputation, variety of offerings, and so on, not objective criteria. For example, gasoline of a certain octane rating produced by different petroleum refiners is objectively very much the same. Yet each corporation in that industry spends vast sums every year to create in consumers’ minds the impression that its brand is superior to the others. If firms in the emerging telecommunications industry largely deploy the same menu of technologies and kinds of offerings, the content of offerings looms as one major method of achieving a high degree of product differentiation. The disadvantages to a firm of failing to achieve a reasonable degree of product differentiation are, first, that it cannot increase rates and hold customers if competitors do not follow suit; sellers are even forced to match the rate reductions of competitors in order to hold customers. Second, sales promotion will be ineffective in attracting customers or in securing higher rates since buyers already view the competing outputs as perfect substitutes for each other. The inexorable trend, then, without product differentiation, is for profit margins in such industries to be thin, since any rate movement upward can be viewed as a rival’s only opportunity to increase market share by not following suit.¹⁵

When one introduces a reasonable degree of product differentiation, all of this changes. Advertising and promotion become important in attracting customers. Sellers are no longer bound to sell at a single rate, and they may elevate rates if consumers are led to believe that a particular offering is superior to competitors’ (even if the belief is objectively false). There are, of course, a variety of ways in which one firm can differentiate its products from others, including advertising and promotion. But from the perspective of any hypercommunications firm, one of the most effective can be to offer content different from that of its rivals. It is from this perspective that close links between information-transmission firms and those in industries that have traditionally specialized in the generation of content aids product differentiation. I refer, of course, to the Hollywood film factories and their distributors as well as their counterparts in television program production and distribution. Their great invention—the star system—is the most successful example of product differentiation ever seen. Entertainment companies, after initial periods of resisting such advances as VCRs and cable television, now take full advantage of them to their enormous profit. Potential new outlets, such as full motion video on the Internet, can only be a mouthwatering prospect to the dream merchants. Large entertainment firms are already deeply involved in other information sectors.¹⁶ From the perspective of the information-transmission firms, such links go a long way in solving the problem of product differentiation.

It is conceivable that any of the dominant telecommunications firms can go it alone in two or more of the submarkets, but it is unlikely that they can do so in all of the submarkets. Consider, for example, Sprint, which began as a long-distance provider but is entering the local telephone market, constructing a digital wireless and paging network, has giant international partners in Deutsche Telekom and France Télécom, is building high-speed connections to the Internet, and is selling movies and other entertainment programs with cable partners. Like other large telecommunications firms, Sprint sees a significant advantage in providing one-stop shopping and a seamless network. In the succinct words of G. Christian Hill, a Wall Street Journal analyst, the emerging hypercommunications firms “want to sell you the bundle.”¹⁷ For this reason, close links have been established between Time Warner, US West, PCS Prime, and BellSouth. In summary, because of the risks and incentives set forth in this section, the twenty-first century portends the emergence of hypercommunications groups embracing local-loop service, international long distance, national long distance, cable television, Internet provision, satellite, wireless (cellular, PCS and other technologies), and entertainment components with selected equipment vendors linked to the group.

AT&T’s split into three corporations—NCR, Lucent, and AT&T—announced in September 1995, does not negate the central trend in hypercommunications. AT&T conceded that NCR was a bad acquisition, never fitting into the larger firm and never becoming a major factor in most parts of the computer business. AT&T’s equipment arm, according to telecommunications analyst Jack Grubman, “makes the world’s best network technology. They never have sold one dollar’s worth of equipment to MCI, British Telecom, France Telecom, or other operators around the world who fear AT&T on the service side.”¹⁸ Obviously, AT&T’s strategic consideration in spinning off Lucent was that the world’s best network technology manufacturer would continue to sell to AT&T and pick up many other large buyers as well. But, as we have seen, AT&T has also entered the other key submarkets directly or through purchase, such as wireless provider McCaw Cellular. AT&T has also invested in Direct TV, a direct broadcast satellite (DBS) firm that competes with cable television. It, too, intends to cover all bases.

Cable Television

The history of cable television, a communications medium not yet discussed in detail, illustrates the risks and tendencies described in the last section. Cable television began modestly, gradually changing its structure, and is now on the road to sharing in the new hypercommunications market. At the same time, it is being challenged on its home turf by other technologies, such as DBS. Finally, its strategies have been shaped by F.C.C. actions, judicial decisions, and legislation, most importantly the Telecommunications Act of 1996. Cable television has been defined as a medium that distributes television signals through wires (at first coaxial cables, more recently optical fibers in many systems). In its early days cable television was able to serve several complementary functions that aided the new over-the-air television networks. First, during the period in which the F.C.C. imposed a freeze on television licenses that ended in the early 1950s, cable television was able to bring television to small and medium-sized communities. Second, even after the freeze was ended, cable television was able to provide reception to areas that could not be reached by over-the-air television. Third, it often provided improved clarity compared to over-the-air TV. This included not just rural areas and television sets distant from local television station antennae, but urban areas as well, in which tall buildings and other sources of distortion interfered with good reception. Thus, in the early stages cable television was not conceived as a threat to over-the-air television but, rather, as a beneficial supplement. Because of its rural roots, the service was at first known as community antenna television (CATV).

John Walson, Sr., of Mahanoy City, Pennsylvania, has received public distinction as “the father of cable television.” He was a line serviceman for the Pennsylvania Power and Light Company who also owned an appliance store at the time that television sets were first being mass marketed. Having found that video signals could not be received in his area due to the surrounding Appalachian Mountains acting as a barrier; in 1948 Walson erected a large antenna on top of a seventy-foot utility pole and strung flat wire from the antenna down the mountain to a warehouse. With the help of amplifiers positioned along the wire route, he was able to provide reasonable reception of television programs in order not only to sell television sets but also to obtain subscribers to his cable connection. For this service he charged a one-hundred-dollar installation fee plus monthly subscriber fees of two dollars.

Other students of CATV history recognize a system constructed by Jerrold Electronic Corporation in Lansford, Pennsylvania, as the first community antenna television system specifically designed to earn a profit. Early in 1950, Jerrold offered three amplified television signals to subscribers in Lansford who paid an installation charge and agreed to pay monthly service charges.

Another system was constructed by a store owner wishing to dispose of a backlog of television sets in Pottsville, Pennsylvania, about twenty miles from Lansford. The owner obtained permission from the town council, negotiated a contract with the local telephone company to attach cables to their poles, and within a year enlisted a thousand subscribers to his service. Originally, this system offered only two channels, but later service was expanded to five channels, including an independent station and an educational one.¹⁹

Most cable companies in the earlier days of cable television conveyed their signals to the subscriber by running their wires on poles belonging to existing utilities. The utility companies reserved space on poles to be specifically used for cable television transmission. Because cable systems arrived many years after telephone and electric service, there was not a regulatory agency to require entrenched telephone and power utilities to share their poles with the cable systems; cable operators could gain access to the utility poles only by contract with telephone companies for pole attachment space. Initially, telephone companies attempted to gain ownership or control of the broadband cable used to provide cable television service. However, their attempts were thwarted by a number of F.C.C. decisions. Unable to maintain their own CATV channel services, the telephone companies began demanding vastly increased cable television pole attachment rates. Problems relating to the cost of erecting poles and pole attachment surfaced in the early 1950s. In 1951, the F.C.C. attempted to remedy the problem and decided that a pole attachment agreement was required as a condition for the procurement of a municipal franchise. However, the commission later decided that the resolution of the problem should be in the hands of legislators. A number of bills regarding pole attachments were introduced in Congress, and eventually the Communications Act was amended to resolve this issue. Under the statute’s provisions, the F.C.C. was granted jurisdiction to set the rates, terms, and conditions for pole attachments unless a given state already had its own pole attachment regulations.²⁰

From its inception in the late 1940s until the enactment of the 1984 Cable Communications Policy Act, the cable television industry experienced three major developmental phases. Initially, cable systems were constructed to bring conventional broadcast programming to remote areas that were unable to receive over-the-air television signals. From 1948 until 1961, cable systems were able to operate in an environment relatively free from governmental intervention. CATV did not require special regulation because cable was merely doing what the television system would otherwise be unable to accomplish. However, as cable became more advanced, it began importing distant signals by microwave to supplement local broadcast programming, and governmental oversight began. Following a landmark 1962 Supreme Court decision, cable television, particularly in respect to the importation of distant signals, became subject to F.C.C. regulation.²¹ The principal reason that the F.C.C. moved to regulate CATV was that the service was becoming not just a supplement to over-the-air television but a competitor as well. The battle between the two groups, in an early example of the process of market convergence, came to a head before the agency in 1958. A complaint had been filed under the Communications Act of 1934 by over-the-air television licensees against 288 CATV operators in thirty-six states. The commission was asked by a group of Western broadcasters to enjoin cable systems from carrying their programs and to declare the cable systems to be interstate common carriers.

The primary reason for the complainants’ interest in subjecting CATV to the commission’s common-carrier jurisdiction was the alleged adverse economic impact of such systems on local television broadcast stations.²² The independent cable programming that disturbed the over-the-air systems was very modest by contemporary standards; cable systems began carrying FM radio stations and weather scans in which local advertising messages were printed on the screens containing weather information. Nevertheless, over-the-air stations saw the danger to their interests that could be imposed in the future and decided to act early before the CATV interests became powerful. In 1966, deluged with over-the-air broadcast complaints against the industry that was now becoming known as cable, the F.C.C. issued regulations requiring cable systems to carry all local television channels, and prohibiting the importation of distant signals duplicating local over-the-air television stations’ offerings. The Supreme Court in 1968 again upheld the F.C.C.’s authority to issue such rules, even though they would retard the new industry’s development.²³

In 1969 the F.C.C. began to do an about-face, recognizing the increasing importance of independent cable origination. In that year 2,260 cable systems served more than 3.6 million homes. Earlier in the decade, entrepreneurial Tele Promp Ter introduced pay television in a world-championship boxing match. Technical quality of reception had improved dramatically through the introduction of aluminum-shielded distribution cable with foam dielectric. Most importantly, a set-top converter was introduced in 1967 that broke the previous twelve-channel barrier for home television sets. In short, entrepreneurial activity in the cable industry was compelling regulators to see cable television in a new way. The F.C.C. now allowed cable companies to carry advertising in connection with programs, but in a major restriction and concession to localism, it ruled (later modified) that no cable system with more that thirty-five hundred subscribers could carry any broadcasting signal unless it made facilities available for local program production and transmission.²⁴

Then in 1976 the F.C.C. went too far, requiring cable systems with more than thirty-five hundred subscribers to develop a minimum twenty-channel capacity by 1986, to make channels available to third parties, and to furnish equipment and facilities for access purposes. The Supreme Court in 1979 held that these requirements were beyond the agency’s powers. The Court invited Congress to clarify the agency’s jurisdiction over cable.²⁵ During the period of uncertainty between the 1979 Supreme Court decision and the new federal law enacted in 1984, local governments, covetous of protecting their powers, franchise fees, and leverage over cable television operators, moved aggressively to assert more authority over the medium. The myth of localism, in which cable franchises were expected to be owned by local interests and a number of valuable channels allocated to municipal and local programming (which accounts for the continuing presence of such channels that virtually no one watches), was an invaluable ideological tool to the powerful combination of local governments who have played a major role in shaping federal policy.

The reality was different. Many (perhaps most) of the franchise awards were tainted. For example, Mayor Marion Barry of Washington appointed the two top executives in the city’s cable TV franchise as consultants. In Washington, the partners in the winning franchise included Barry’s media adviser, several of his close confidants, and his reelection treasurer. While overt bribery was not the predominant method in franchising—at least not the discovered preferred method—the “rent-a-citizen” approach typifies most awards in large communities. In Omaha, for example, Cox Cable won the local franchise and included eight prominent Omahans as shareholders in the local subsidiary. These persons made investments in the range of $20 to $40; at the time a $40 investment was expected to yield $1.9 million. The Houston example also illustrates the dynamics. According to the U.S. Court of Appeals for the Fifth Circuit, in 1978 Jim McConn, then mayor, divided the city’s franchises among four applicants, each backed by local political influentials. Later these “local” franchisees sold their valuable franchises to national firms for enormous profits.²⁶

Cities were exploiting the myth of localism in the very period that the cable TV industry was undergoing a dramatic transformation. In 1977 annual cable TV revenues exceeded $1 billion, and giants, such as American Express, came into the industry. TCI, formed in 1968 from smaller cable companies, had twelve employees in that year. By 1975 it was the nation’s second largest cable operator with more than 651,000 customers from 149 systems in thirty-two states. By 1982 TCI passed the two-million subscriber mark.²⁷ Cox Enterprises, a broadcasting company, entered cable in 1962 when it bought a small system in Lewistown, Pennsylvania; by 1972 it had 500,000 subscribers in nine states. Time, Inc., entered the cable business in 1972 with the purchase of Home Box Office (HBO). By 1975 HBO was offering uncut, uninterrupted, relatively new Hollywood movies and special events. One could go on, but the point is eminently clear. By the time of the 1984 Cable Communications Policy Act, cable television had become big business, dominated by a relatively few large firms, which in some cases had become vertically integrated backward into the production of entertainment. By the 1990s the cutting-edge model of a cable company had become Time Warner, Inc., formed in 1989 by a merger of Time, Inc. and Warner Communications. It was in both film and television production and cablecasting, ran cable networks, wireless and paging operations, and data services. Time Warner had an international presence and was linked to a number of other firms in the various telecommunications submarkets. In short, Time Warner had become a quintessential hypercommunications firm. We are a long way from the localism myth.

These trends were clear in 1984 when Congress enacted the first comprehensive statute on cable television. The most important change the act sought was to deregulate cable rates. Congress based its decision on three factors. First, it feared that without a check on franchise fees, local governments would be tempted to solve their fiscal problems by levying a burdensome tax on the cable industry. Second, the legislators believed that the cable industry had matured and was capable of competing with over-the-air television. Consequently, rate regulation at the local level was no longer a necessity. Finally, they concluded that cable services, unlike electricity or gas, were nonessential and did not possess any of the characteristics of public utilities. In short, legislative feeling was that cable deregulation was an idea whose time had come because the benefits of cable technology, which could finally be offered in a competitive market environment, were being impeded by local regulation.

As enacted by Congress, the legislation largely deregulated the cable communications industry and removed most of the ability of municipal, state, or federal franchising authorities to regulate the rates charged by franchisees for the provision of cable service where there was “effective competition.” However, it recognized the power of cities to grant and renew franchises and outlined standard franchise procedures that made cable companies less vulnerable to capricious and harmful decisions.

A sharp increase in cable rates, much greater than the rate of inflation, in the period following enactment of the new statute inevitably led to consumer resentment. A few weeks before the 1992 presidential election, Congress handed President George Bush the sole override of a veto during his presidency. The new statute, since modified by the Telecommunications Act of 1996, compelled cable companies to renegotiate licenses from over-the-air stations for the right to carry the latters’ programming, allowed small over-the-air stations to demand that cable systems carry their programs (the “must carry” provision), and required cable operators who produce popular programming to make it available to direct broadcast satellite (DBS) and other competing technologies. Significantly, the law required the F.C.C. to provide guidelines for local government cable rate making on the “basic tier of services” (consisting of local and network over-the-air and public access stations) and to provide rate guidelines for “expanded services,” such as cable news or sports channels. In the latter instance, consumers and local governments could appeal “unreasonable” rates.²⁸ The statute, needless to say, set off a flurry of F.C.C. rule-making proceedings, some rate freezing, and cable company appeals.

On to the Future

While in broad outline the statute and the F.C.C. actions under it were largely (although not entirely) upheld, the 1992 statute was mainly a sideshow next to the basic changes taking place in telecommunications. By 1992 cable companies were investing heavily in fiber-optic lines that would greatly enlarge capacity. As it is, coaxial cables, which carry less information than fiber, can carry up to nine hundred times the information that copper wires, still widely employed by local telephone companies, can.²⁹ Optical fiber has still other major advantages and important business implications. First, transmission costs will drop because signals can be carried much greater distances without the use of amplifiers, which degrade signal quality. Amplifiers incur high maintenance costs as well. Moreover, fiber optics offers the promise of two-way communications, high-quality voice, data, and video, and more channels. At the same time fiber-optic technology has been improving so that the channel capacity for each fiber has increased from eighteen to eighty video channels.

However, the cable giants are not betting entirely on fiber-optics. Coaxial cable and hybrid fiber-coaxial (HFC) may support a new family of cable modems that promise to operate at speeds up to one thousand times faster than the current family of 28.8 or 33.6 kilobits per second (Kbps) telephone modems used for Internet access, and ten times faster than the telephone companies’ 128 Kbps ISDN line limit. Cable systems, thus, are adding Internet access to their other offerings. Instead of going through an Internet provider, one simply turns on his or her computer with the cable company connecting to the Internet. Of course, the cable companies must reconfigure architecture and dramatically increase the system’s ability to handle upstream traffic. As 1997 began, only 7 percent of the United States’s cable systems could handle two-way traffic, even though more than 70 percent of households had the ability to access cable. The capital requirements to upgrade are obviously enormous. Already @Home and TCI have launched such an experimental service in California, while other major cable companies and partners have begun similar efforts using cable modems in other parts of the country. But like all advanced technologies, cable modems may not work as well as planned, reinforcing the hedging strategy and its implications discussed earlier. Intel president Andrew Grove, for example, after initial enthusiasm and backing, concluded that the cable modem system is “awfully difficult to implement,” endorsing other technologies instead that are closely associated with telephone companies.³⁰

Telephone companies have not sat idly by in the face of the cable threat. During the 1990s, as we noted earlier, they began a series of cable acquisitions, culminating in US West’s 1996 acquisition of Continental Cablevision. After winning court battles against cable systems in the 1990s, US West and other telephone companies launched video dial tone, a system that delivers voice, data, and video signals. Under that system voice signals are split off from video signals with voice sent to the home through copper wires and video carried into the home through coaxial cables.³¹ While the legal status of video dial tone has been in doubt, the telephone companies are now banking on a technology called asynchronous digital subscriber lines (ADSL) to compete with cable modems. ADSL uses filters to split existing copper-wire phone lines into three frequency channels carrying, respectively, telephone signals, data transfers, and either video on demand or WWW information. ADSL’s enormous advantage is that it can use existing phone lines rather than requiring the enormous upgrading cable modems require. But serious questions exist about technological problems, the cost of the special equipment required at consumers’ premises, and the cost of the service. In addition, ADSL requires new transformers, analog filters, and analog-digital converters. Moreover, there are technological problems concerning the dynamic range of sound and noise. Nevertheless, ADSL has been tested successfully. But the road from tests to market is often a difficult one. If that were not enough competition for cable modems, there is also wireless cable, in which a dish is placed on one’s roof that can receive data and pass it down to a modem through coaxial cable. Further, there are various satellite services. On the horizon are local multipoint distribution service (LMDS) and multichannel multipoint distribution service (MMDS), two cutting-edge wireless technologies that use small antennae mounted on window sills. Telephone companies and other players are involved in these new technologies as well.³²

As if this bewildering stew of proven and experimental technologies and the large number of actors were not enough, 1995 and 1996 saw another submarket suddenly grow in prominence. Old and new telecommunications firms, new alliances, and the hedging strategy all played a role in the revival of direct broadcast satellite (DBS) after years of foundering. Prices for the satellite dish, which is now the size of a pizza pan, dropped to two hundred dollars by late 1996. The technology then had four million subscribers and boasted picture quality that put typical cable quality to shame. Moreover, it offered more than two hundred channels. Internet access through DBS was in the offing, as well. DBS’s major problem was that, while it could bring video from around the world, it could not show local TV channels. Symptomatic of the converging nature of communications, cable companies, while competing against DBS, also formed a consortium, called Primestar Partners, to enter the DBS market as a hedge. AT&T, GTE, and other telecommunications companies have also moved into the industry through acquisition or strategic alliances. Thus, from cables below the ground to satellites in the sky, hypercommunications has replaced the separated markets of the past.³³

The Telecommunications Act of 1996

In February 1996 President Clinton signed into law the Telecommunications Act of 1996, the law that recognized the dramatic changes taking place in the telecommunications marketplace. While every player in hypercommunications saw the need for a new statute that would reflect the enormous changes since the enactment of the 1934 basic law, working out the details was an enormously difficult and time-consuming process. Every player agreed to allow entry into its markets. But the issues of when, how, and under what conditions required intense and complex negotiations and lobbying. Of course, those people who thought that regulation would come to an end under the new statute, or that litigation in this highly litigious sector of the economy would disappear, were laboring under an illusion. Indeed, the F.C.C. and state regulators have been very active, and the litigation began on the day President Clinton signed the act into law. Nevertheless, even at the signing ceremony, attended by virtually every player in hypercommunications, executives were discussing mergers, alliances, and entering new markets.³⁴ Access-charge issues and a host of others were continuing to be debated within the F.C.C. and state agencies notwithstanding the new law.

Even though the 1996 act will hardly end regulation and disputes, the statute has been widely viewed as a great leap forward. Perhaps the most important aspect of the statute is the recognition that telecommunications has become a converged market and not a set of discrete ones. Television, cable TV, entertainment, computers, wireline telephone and wireless, and other sectors were conceived as a single hypermedia market, the combined revenues of which approached $1 trillion at the time President Clinton signed the bill into law.³⁵ While the general thrust of the law is clearly in the direction of allowing more open competition, restrictions nonetheless remain. Cable companies are forbidden to purchase telephone companies except in rural areas, but they may purchase up to 10 percent of a telephone company elsewhere. Large cable company rates for extended basic service will not be deregulated until 1999, except where a telephone company delivers a comparable cable service. Cable companies may provide telephone service, and local telephone carriers are required to assist any new competitors, including cable companies, in the areas of interconnection, access, and number parity. Restrictions on over-the-air television stations have been liberalized, although any television station owner may reach no more than 35 percent of United States homes. Broadcast companies may own cable stations. A network may not purchase a competing network, but may create new ones.

Telephone companies are bound with rules that parallel those of cable companies. They may not own more than 10 percent of a cable company and are prevented from buying cable systems, except in areas with fewer than thirty-five thousand people. They may, however, provide video programming. If they do so, they may choose to be regulated as a cable system, common carrier, or “open video system.” If they choose the third classification, they must offer independent programmers the right to telecast over their systems without discrimination and are generally bound by the local and national rules covering cable systems. Local telephone companies are permitted to offer long-distance service, while long-distance carriers can offer local service. Each will be bound by the applicable F.C.C. and state rules covering the service they enter. Local carriers enjoying a de facto monopoly must show that there is effective competition for both residential and business subscribers before they are allowed to enter equipment manufacture and long distance (which, of course, has had effective competition). Finally, all telecommunications companies must contribute to a universal service fund that assures that everyone will have access to the system.

The statute also contained provisions concerning transmission of “indecent” material over the Internet—provisions rapidly declared unconstitutional by lower courts—and using the Internet to inflame people. The Internet, in short, remains largely a free, open, and competitive structure. Television set manufacturers are required to include a “violence microprocessor” (V-chip) that will read a rating signal accompanying each program and block those considered undesirable by the viewer. This requirement does not go into effect until V-chip technology is developed and proven. Television broadcasters were required to develop a rating system indicating the degrees of violence, sexual content, and vulgarity in each program and assign the rating to each program. There is much more in the 280–page law, but the broad contours are generally in the direction of more openness and competition, as the foregoing description indicates. Lurking in the background is the advent of high definition television (HDTV), soon to come on line. What its impact will be on the hypercommunications stew remains to be seen.

What Hath God Wrought!

In 1832, during a leisurely ocean voyage returning to the United States from Europe, Samuel F.B. Morse conceived the idea of transmitting letters, and therefore words, by an electromagnetic device. Benefiting from the advice of the great scientist Joseph Henry, Morse gave a demonstration of his new device, the telegraph, in 1837 before a group of scientists at New York University. In 1843 Congress appropriated $30,000 to demonstrate the device on a line between Washington, D.C., and Baltimore. On May 24, 1844, Morse tapped out his famous message—“What hath God wrought!”—and set in motion a revolution, the effects of which continue to be experienced into the foreseeable future. Morse and Henry, as brilliant as they were, could have no sense of the enormous social, economic, and technological changes that would be wrought only a few years after the telegraph’s invention. Similarly, one would be foolhardy today to predict what the future of telecommunications holds in ten, twenty-five, or fifty years’ time. But the past does hold lessons, the most important of which can be summarized in two words: Don’t overgeneralize.

Bearing this caution in mind, there are several persisting themes in this examination of what is now one-sixth of the United States economy. Almost from its beginnings telecommunications became a major factor in the process of control. In 1851 the New York and Erie Railroad installed a telegraph line that allowed the company to coordinate and control its operations as never before. Today, a global economy is possible only because the speed of communications allows any company to control operations and dealings throughout the globe from a central facility. At the same time, the ability of telecommunications to control implies an important note of caution. A surfeit of information does not imply that the information is accurate or beneficial; one can only recall Adolf Hitler’s remarkable use of the radio during the 1930s to poison the minds of the German people. In less dramatic fashion the United States Congress’s insistence that future television sets include a V-chip attests to the negative impact that powerful telecommunications can have. But this is only to suggest that technologies bear costs as well as benefits. The technology itself cannot be blamed; all other things being equal, technological progress should be welcomed. Telecommunications technology has, on balance, made our lives immeasurably better, both in overcoming solitude for individuals and through its innumerable business applications.

We, therefore, owe a debt of gratitude to the many engineers, scientists, and innovators who have been mentioned in these pages. From the innovators who formed and guided Western Union in 1855 through those at Sun Microsystems who, in 1995, gave us the Java programming language for the WWW, a continuing theme in this book has been the central role of innovators in advancing telecommunications. But note, an innovator is not an inventor. Invention alone has no economic or social effects. An innovator is one who combines invention and investment. Steve Jobs, as we saw in the last chapter, visited Xerox’s research facilities, observed many inventions, invested in developing them, and radically transformed the PC from a scientific tool to a consumer product. Innovators are often entrepreneurs who, in Joseph Schumpeter’s words, “reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old one in a new way, by opening up a new source of supply … or a new outlet for products, by reorganizing an industry and so on.”³⁶ Yet the very risky activity of bringing new services to market, as we have seen, has been undertaken not just by small start-up companies, but by such giants as IBM and AT&T as well. Indeed, AT&T, while still a monopolist, probably compiled the finest record of innovation that the world has ever seen.

And just as one must be wary about facile generalizations concerning the size of firms or the extent of competition that leads to innovation, one must also be careful about the role of government. In what is perhaps his most widely quoted statement, Adam Smith observed:

Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…. By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.³⁷

But while extolling self-interest as the underlying source of wealth, Smith recognized in many places a role for government. We will never know whether or not the Internet would have been constructed if the United States government had not been involved. We do, however, know that government organized the effort that led to the remarkable commercial and social benefits that take place on the Internet. Indeed, Adam Smith recognized the important role of government in subsidizing very large scale projects, especially if they relate to national defense or some other great public good that the market will not readily undertake. The experience of socialism has rightly made us very wary of government control. But this in no way supports the reductionist argument that government can serve no role (other than central banking) in the economic arena. Government has subsidized and supported many important economic developments and, as portions of this book have sought to show, it has often regulated industries and disputes effectively. Certainly we should be very wary of government intervention, with its long record of oppression throughout history in most of the world. But there are always situations in which desirable results “cannot be attained at all or attained only in inappropriate amounts if left to the free market.”³⁸

We must, in short, be wary of overconfident judgments, not only about the future of telecommunications technology but about such other factors as business structure and government involvement. Our watchword should be, “It all depends.”